Stock market regulators across the globe find themselves in a tight spot with regard to algorithmic trading. Instances such as the flash crash in Dow or the Muhurat trading mishap on BSE have them worried. But there isn't enough evidence to suggest that these trades need to be stopped altogether.

Mr U.K. Sinha, SEBI Chairman, is not the only regulator who has been publicly wringing his hands at the algo quandary. Others such as the Securities and Exchanges Commission (SEC) of the US, the International Organisation of Securities Commissions (IOSCO) and market regulators in the European Union too have voiced concern on system generated trading and a flurry of discussion papers have been put out on the subject.

Global menace?

It was reported in The Wall Street Journal that the SEC Chairman, Ms Mary Schapiro, had said that there are concerns regarding algorithmic trades but data available at this point is insufficient to justify significant additional steps.

She had also said that regulators needed to have a much deeper understanding of the impact of high-frequency trading on the markets. IOSCO in its consultation paper issued last October had also toed a similar line.

That sums up the situation that market regulators currently find themselves in. They have allowed system-based high frequency trading to increase without thinking through the implications or the precautions that they need to take.

These trades now account for more that 50 per cent of turnover on US and European exchanges and about one-third of the turnover in cash and derivative segment of the National Stock Exchange.

SEBI order

Fortunately, regulators are now beginning to act. SEBI, in its recent order on algorithmic trading, has listed some of the checks that exchanges and stock brokers need to have in place.

The exchange-level checks include imposing economic disincentive for high daily order- to-trade ratio, ensuring that all algorithmic trades are routed through broker servers in India and stipulating that exchanges should have both quantity and price checks for such orders.

Once a broker's terminal is shut down on exhaustion of collaterals, it has to be switched on again only manually after following all risk management procedures.

Exchanges have to ensure that stock brokers providing algo-trading facility monitor price, order quantity, order value and open order value of these trades during the trading session. The algos used by them have to be ratified by the exchanges. The brokers are also required to give an undertaking that they have incorporated the requisite checks.

Many of these checks are already being followed by some exchanges and brokers. By mandating that all exchanges and intermediaries have to follow the requirements in the order, SEBI has now passed the onus of thwarting a systemic failure to the exchanges. Exchanges and brokers can now be hauled up for not taking adequate precaution.

Some requirements in the order such as exchanges identifying dysfunctional algos (in advance) and disabling them appear impractical. Inexplicably, SEBI has also left collocation facilities out of the ambit of this order.

Why the haste?

The Indian stock market regulator along with its peers has to now to play it by the ear in tackling this high-speed contrivance. The moot question is, why did SEBI not put in the checks earlier and why did it allow collocation facilities?

Surely the regulator knows that the high impact cost and scant liquidity on most counters in our market is not conducive for such trades.

SEBI could have followed the RBI's example in going slow in adopting glamorous international practices that can have serious consequences.

Everyone knows that this prudent stance helped insulate the Indian banking sector from the 2008 crisis.

lokeshwarri_sk@thehindu.co.in

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