Perhaps no
other part of the capital markets universe is as cloaked in mystery as
algorithmic (algo) trading. The very mention of this business conjures visions
of silent, powerful machines that never go to sleep as they trawl the global
markets. Swooping on instances of mispricing across paired products or markets,
they then seek to profit as the established relationship is restored, through massive
market orders. Their rise has mirrored
the increasing influence of quantitative trading strategies in today’s capital
markets.
Such
predominance has been made possible also through another key ingredient: - co-location
(colo). As the value of algo trading took root in the trading floors of the
world, firms sought to replicate algo strategies which drove down the scale of
business profits. Co-locating the firm’s servers in the physical premises of
the exchange alongside the exchange’s servers became an essential ingredient of
processing and trading on market movements. Effectively, this led to a two-tier
trading structure – one, comprising the algos and their higher trading volumes
(and fees) and the rest of us, who despite our large trading numbers delivered
a far lower average turnover and fees. This ensured that exchanges that were
able to cater to the economic requirements of algo trading houses were able to
ensure fat fees and also enhance their promoter’s equity valuations. In India, this
has been a game that has largely been won by the NSE, as evident in the valuations
observed in NSE stake sales.
Irksome questions
have now been posed about this merry party that have grave implications for the
integrity of the Indian capital markets. The troubling conclusions represent a
formidable test of the resolve of the market regulator which itself is in the process
of merger. At the heart of this case are the fantastic allegations
that have been made by the respected journalist Ms. Sucheta Dalal in the magazine
Moneylife. These in turn are based on a “whistle blower” letter that made its
way to the magazine. It purports to show in shocking operational detail how a
cabal of key traders aided by NSE’s operations staff managed a ring-side seat
in the exchange’s algorithmic trading set-up. Further, by determining which of
the clients were able to receive trading information with a lower latency than
other, NSE’s staff also enabled these firms to trade on this information and
enrich themselves at the expense of this HFT peers and the wider market.
To be sure,
this missive is not from a whistle-blower (i.e NSE or affiliated employee) in
the conventional sense of the term. The letter specifies that the author is a
former employee of a HFT client of the NSE. Further, the individual’s motives
are not guided by altruism. Rather, it is alleged that the NSE has given “structural
advantages which are more difficult to prove” as “in quid pro quo for keeping quiet”.
This arrangement, the letter mentions “is resulting in degraded performance of
the algos” and “difficult for us to work in an unlevel (sic) field”.
Ms. Dalal
followed up on this missive by attempting to receive a clarification from the
NSE. Here, it appears that the well-respected exchange has faltered, first by
failing to respond knowing about an impending article and then following up
with a multi-crore defamation case on Moneylife. What appears to have miffed
the exchange is the allusion in Moneylife’s articles
that the Finance Ministry is seized of the matter and which has in turn led to
SEBI’s and the RBI’s scrutiny
of the NSE and HFT. Further, stock market crashes in the preceding months have
also been attributed
to algo trading.
In its judgement,
the Bombay HC has come down heavily on this approach of the exchange.
Highlighting how specific paras of the NSE’s response to the court are “yet
another attempt at misdirection”, the HC goes on to lambast the NSE’s response
as being drafted “in the hope that the judicial mind can safely be presumed to
be ignorant of all matters technical and too easily overawed by an outpouring
of technical jargon”.
After remarking that “Our Courts are not
to be treated as playgrounds for imagined and imaginary slights for those who
command considerable resources”, Justice Patel proceeded to impose financial
payouts on the NSE towards Moneylife’s editors and to public cases. As of going
to publication, the NSE has secured a stay
on its implementation.
India’s LIBOR moment?
This case is remarkable
as much for the facts surrounding it as much as it is about the limited coverage
it has received. This situation is hardly an exception if the lenient, indeed
near-fawning, coverage of Indian industry in the popular press is any indication.
Indeed, a free press and freedom of speech are important cornerstones of Indian
democracy. However, the press should realize that corporate governance is a key
element of ensuring the rule of law applies to the corporate jungle. Where the
press is silent or subservient to those with deep pockets and their shenanigans,
is it not a slippery slope to cronyism, public corruption and the breakdown of
law and order? To its credit, the government of the day has been extremely
pro-active on this front, working with Indian industry to ensure the fair
allocation of mineral resources, mandating that e-allocation be the framework
for all public resources, and demanding that firms focus on investment rather
than demand subsidies and erecting barriers to trade.
This case and its
handling is also an important test of SEBI’s resolve to implement the rule of
law and stand up to rule-breakers, no matter how powerful. Coming as it is on
the back of the NSE-FMC merger, there is an urgent need for all regulatory
agencies to work in a coordinated fashion, with the Finance Ministry leading
the policy efforts. This can be first achieved by the NSE being transparent
with the regulators and sharing an open assessment of issues identified, if any
and their remediation.
It is naïve to expect
that an organization can remain immune to some individuals who prioritize
short-term, personal gain over the long term good. Instances like the LIBOR
scandal have shown how even supposedly “good-standard” benchmarks can be consistently
rigged across multiple firms. Public exchanges thrive on the value of their
good name and the rule of law in capital markets. Any attempt to muzzle the
free press run contrary to the image of a fair, innovative and
technologically-savvy institution such as the NSE.
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