The case involving the National Stock Exchange and Moneylife is attracting a lot of attention because it is a classic David versus Goliath fight with the exchange behemoth currently on the backfoot. But the matters that the case deals with — algo trades and co-location facilities — would not interest a lay investor much. It’s mainly about stockbrokers trading with their own money, and their institutional clients who make use of these facilities.

Stock exchanges globally allow trading members to buy rack space close to the exchange servers, called co-location facilities. By doing this, the speed of order execution is increased manifold, thus giving a leg up to algos that depend on latency or speed. The article in Moneylife , that triggered the defamation case, was based on the complaint of the whistleblower, a Singapore-based trader with a hedge fund, that a particular user of the co-location facility was able to be ahead of others in the queue for order execution by obtaining information from an NSE insider about the time when the servers would be switched on. An apt analogy for the complainant would be one of a spectator sitting in the most expensive seat with the best view in a stadium complaining that he is unable to view the match because the person in the row before him is too tall. It is, in order words, a complaint by someone who has a rack space next to the exchange servers, that he is slightly disadvantaged in relation to other similarly placed traders. But of what relevance is this to ordinary investors, who are not into algo trading?While the debate thus far has centred around whether the NSE was right or wrong in acting the way it did, there are a few other points that need due consideration. For instance, how was the ecosystem for algo trading including co-location facilities created and whether their merits were examined carefully before introduction?

The right debate

Those rooting for these facilities put forward many arguments why these are required, but most points are debatable. For instance, it is said that volumes on Indian exchanges have increased sharply since the introduction of algos and co-location facilities; in both cash and derivative segments. The spread between the buying and selling price on trades has also reduced since then. While this is true, the trading volume is concentrated in the top 200 stocks and lack of liquidity in many counters is still an impediment to investors.  

Two, it is argued that foreign institutional investors using automated trading in other countries would be piqued if these were prohibited in our country. The question that needs to be asked here is, what kind of foreign investors we want to attract into the country — the short-term kind who trade through the day with algos or the long-term ones who prefer to invest in the country’s growth? The latter are not likely to be interested in algos.

Three, those willing to pay a higher sum do enjoy privileges, in all fields. But is it right to apply this logic to an exchange that has to ensure parity between the services offered to all investors? Again since exchanges are willing to sell rack space to everyone who wishes to buy them, there is purported to be parity in the offering.

How did it happen?  

It began in 2008, when SEBI gave permission to trading members to give direct market access (DMA) to their institutional clients. The DMA was to allow large clients to put in orders in the exchange server directly, without any intervention by the trading member. By giving permission for the launch of DMA, the regulator also implicitly gave permission to use algo-driven programmes for trade execution.

In August 2009, the NSE invited applications from its trading members to buy rack space close to the exchange server. There does not appear to be any circular or discussion paper put out by SEBI prior to the launch of the co-location facilities. In 2013, SEBI put out a discussion paper on co-location facilities and in August this year, the market regulator did an in-depth study of this system and came out with detailed guidelines.

The worrying part is how algos and co-locations have seeped into the market without any public discussion on whether they were needed at all. Given that exchanges and regulators in other countries are also befuddled about the benefits of algo trading, SEBI could have moved a little slower. A more conservative approach in adopting global practices with questionable merits in future will serve our markets better.

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