Monday, June 29, 2015

Concerns over risk in Algorithm trading - Technology Boon or Bane ?

Financial regulators are alarmed by the increasing clout of algorithm trading or high frequency trading (HFT) and fear that it could result in a systemic failure.

 The Financial Stability Report (FSR) June 2015, released last week, aired serious concerns on algorithm trading or algo trading leading to stock price manipulation as well as alienate retail or small investor from stock markets.

 The report is a collective assessment of a sub-committee of the Financial Stability and Development Council, which includes all financial market regulators. Interestingly, the reports in the past have also emphasised the risks involved with HFT.

 While volumes have increased sharply in the cash segment of stock markets in India, there is a concern whether markets could be rigged through these trades. Algo trading has undergone a substantial change with the development in information processing and communications technologies over the last two to three decades.

 Algo trading was introduced in India in April 2008 with the advent of direct market access (DMA).

Though these trades are monitored by the Securities and Exchange Board of India (SEBI), which is mandated to protect the interests of small investors, the FSR report expressed apprehensions that they could result in market manipulation.

 “The increased complexities of algorithm coding and reduction in latency due to faster communication platforms needs focussed monitoring as they may pose risks in the form of increased possibilities of error trades and market manipulation,” FSR report released this week noted.

The report also pointed fingers at certain instances of abnormal market movements in Indian stocks which have been attributed, by market experts, to algo trading/HFT.

Close watch

SEBI keeps a close watch on the developments to formulate appropriate policies based on recommendation by the Senior Supervisors Group (SSG), a group of 10 supervisors which issued a report on April 30, 2015 that assesses risks associated with algorithmic trading.

The increasing volume of algo trades/HFT and their attendant risks have forced regulators the world over to have a closer look at gaps in the existing regulations and explore ways of strengthening them.

The global debate on this issue was triggered by Michael Lewis’s best-selling book,  Flash boys: A Wall Street Revolt,  published in March last year, which discusses the rise of high frequency trading in U.S. equity markets and argues that the U.S. equity markets are rigged by the HFT traders.

“The debate over whether algo trading is good or intrinsically bad is a philosophical divide that is now becoming universal.

“The key is to check whether the system is being abused as a manipulative device or an innovation. The truth lies in between,” says Somasekhar Sundaresan, Partner, J. Sagar Associates, advocates & solicitors. According to him “every system is capable of manipulation.”

 The algo trading system too has the capacity of being harnessed for the betterment of the market with greater liquidity, finer spreads and less volatility, says Mr. Sundaresan, adding, “the new technology needs to be embraced and harnessed for prevention of abuse rather than be shunned for fear of the unknown.”

 However, the moot question remains whether Indian markets are matured enough to embrace algo or high frequency trades?

While huge institutional investors will be able to take advantage of arbitrage of micro and nano-seconds, by engaging in high frequency trades, the interest of retail investors could be jeopardised.

While huge institutional investors will be able to take advantage of arbitrage of micro and nano-seconds, by engaging in high frequency trades, the interest of retail investors could be jeopardised

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