The regulator’s apprehension is, in part, fuelled by an acute lack of insight and understanding of the role and function of speed traders within capital markets.
High frequency traders have often received an anxious and sometimes hostile demeanour from regulators and market participants alike. Popular perceptions with respect to these traders’ supposedly predatory and unfair strategies have been captured with imaginative narrative in several books, including Michel Lewis’s Flash Boys. While such bestsellers provide a fascinating read of this particular market segment, creeping popular perceptions into expert regulatory strides are both worrisome and often amount to squandering.
Indian capital markets regulator the Securities and Exchange Board of India (SEBI) recently published a discussion paper – ‘Strengthening of the Regulatory Framework for Algorithmic Trading and Co-location’ – that is substantially, if not entirely, directed towards high frequency trading (HFT). The discussion paper notes several concerns with respect to HFT and its impact on “market quality” and “market integrity” as the basis for its proposed regulations. Worryingly, in a singular fashion, SEBI proposes to introduce a whole host of measures, including random speed bumps, minimum resting time and frequent batch auctions, which are directed at creating a level playing field between HF traders and non-HF traders. Market participants and academic experts have been prompt in pushing back the set of proposed measures as being incredulous and inimical. What is worrying, however, is the regulator’s tepid approach towards fully examining the issue and in providing a credible perspective towards its resolution.
Indifference, imprudence and inadequacy
Financial and securities regulation is notorious for its partial reach, unintended consequences, regulatory capture and for often being malefic to fast moving technology and innovation. Thus, anxious and meticulous consideration ought to be given to any new piece of regulation so as to minimise incidental costs and augment its benefits. SEBI through its discussion paper, however, displays a nonchalant approach to both fact finding and rigorous analytical research, inasmuch as it captures no insight, experience or study of the Indian securities market and the role of algorithmic trading within it.
To the contrary, it wholeheartedly relies on unknown academic literature and the experience of “regulators across the world” without any indication of either its probative or crossover regulatory value. Indeed, securities markets differ from each other with respect to its participants, products, volume, efficiency and robustness, and therefore regulatory focus and attention demands a reflective approach. This divergence in treatment and perspective with respect to HFT was highlighted very recently by the Financial Conduct Authority, admitting to the differing landscapes of regulatory oversight in US and the UK.
Equally troublesome is the regulator’s exposition of several measures that are directed more at nullifying the speed advantage of HFT rather than identifying and ameliorating its disruptive practices. Considering the fact that HFT is not of a singular design, differing strategies impact the market in varying ways and indeed exhibit separate concerns.
For instance, passive market-making strategies, where HF traders act as liquidity providers, by placing non-marketable limit orders, have been observed to contribute towards increased liquidity, reduced bid-ask spreads and on an average reduction in volatility of stocks. Clearly, substantial benefit accrues to small scale retail investors from the fact that HF traders compete amongst themselves in providing for liquidity, order fulfilment, fairer prices and swifter execution. On the contrary, aggressive trading strategies such as momentum ignition, spoofing and quote stuffing, which contribute to ‘fleeting liquidity’, exhibit an ambivalent interpretation, contributing positively to efficient price discovery, and negatively to increased transaction costs and volatility. While in the US and the UK such practices are of relatively greater visibility, in the Indian context preliminary research suggests that incidents of such practices are rather few and dispersed. In the absence of credible data, proposals contained in the paper like ‘minimum resting times’ and ‘delay in order processing’ on all orders have the potential to do more harm than good, especially when market liquidity in India is both a matter of concern and focus.
Regulators overseas have therefore considered and rejected proposals on requiring time lags, citing concerns related to stale orders, increased transaction costs and market volatility, especially during crisis periods marked by withdrawal of liquidity providers. Similarly, proposals on frequent batch auctions present not only considerable operational and administrative bottlenecks, but requires a complete overhaul of current market infrastructure, both at the level of monitoring and execution. However, the SEBI discussion paper does not encompass any indication of its contingency, viability or desirability.
Further, SEBI’s intransigent approach in identifying co-location as unfair and inequitable, completely misses the point that different market players participate with differing objectives and thus do not compete at the same level. Non-co-located/non-HFT long term traders indeed do not seek to exploit short term market inefficiencies and therefore speed or the lack of it, is hardly the decisive aspect of their trade. However, as far as, access to co-location is concerned, a set of fair, transparent and equitable terms applying to all market players, removes any notions of co-location as offering ‘unfair’ or ‘inequitable’ access. In similar vein, regulators overseas have refused to characterise access to co-located servers in trading centres as ‘inherently unfair’. The discussion paper, nonetheless, offers precious little with respect to any definitive access criteria, while reintroducing its earlier debunked proposal on a two tiered system for co-location and non-colocation orders.
As it stands, the proposed measures are at best premature and at worst, counter-productive. A lot of the apprehension is fuelled either by an acute lack of insight and understanding of the role and function of ‘speed traders’ within capital markets, or a perceived sense of injustice and unfairness subsisting within popular discourse. Thus regulatory bodies like the SEC, CFTC and ASIC, have adopted an incremental approach characterised by increased supervisory functions, imposition of risk management systems, ex-post circuit breaker mechanisms and targeted enforcement actions rather than adopting blanket industry wide constraints.
A troublesome road to regulation
Of even greater concern however, is the shoddy state of regulatory governance in India, where regulators rarely articulate any thought or reasons for measures proposed to be adopted. Best practices internationally have gradually moved towards imposing a legal obligation on regulators to undertake a cost benefit analysis of a certain standard, justifying their stance and position. Alas, SEBI seems to have completely ignored the recommendation of the Financial Sector Legislative Reforms Commission, or FSLRC, and the finance ministry on undertaking a cost-benefit analysis, despite its own affirmation to the same. A case for rigorous scrutiny becomes even more profound considering the ambiguity of several research studies concerning the negative market impact of HFT. Therefore, regulatory intervention in the US, UK and Australia, has called for much greater caution and circumspection and has been guided by several policy papers, concept notes, literature review documents and reports, to bridge the gap between presumptions and data backed analyses.
In India, however, complacency, short-sightedness and a yearning sense of haste is steadily becoming the norm for financial regulators. Discussion/consultation papers have been introduced in the past only to be severely criticised within both academic and policy circles leading to an abrupt regulatory hiatus. Remember crowdfunding? Peer-to-peer lending?
Invariably, technology and innovation driven sectors seem to be driving our regulators into a no endgame cat and mouse play, where the cat is increasingly exhibiting both imprudence and obscurity. Inevitably troublesome is the regulator’s indifferent approach towards fact-finding, analysis and research coupled with its vague assertions and equally indefinite presumptions. In consequence, the discussion paper brings meagre little to the discussion table and in most respects, relies much on fiction than on facts.
Kanad Bagchi is a doctoral research fellow at Max Planck Institute for Comparative Public Law and International Law, Heidelberg, Germany.