None exists at present; calls abound for regulations as volumes swell on use of this technology
The commodity derivatives market regulator, the Forward Markets Commission (FMC), may decide to issue rules for algorithm (algo) and high-frequency trading.
“There is no proper guideline. Neither has the Commission prohibited any traders from exercising algo or high-frequency trade. We are examining the issue. We will take a view in this regard soon,” said Ramesh Abhishek, chairman of FMC.
Some bulk transactions are done automatically through computers in which algo software is installed. The software, linked with news agencies, captures online information from various sources and executes orders on its own in micro-milliseconds, before an individual investor can analyse and decide. By the time, a common trader acts on the news and takes a decision, the price changes.
Algo trading is widely used by investor-driven institutional traders, to divide large trades into several smaller ones to manage market impact and risk. Sell-side traders, such as market makers and some hedge funds, provide liquidity to the market as well as generate and execute orders automatically. It can be used in any investment strategy, including market making, inter-market spreading, arbitrage or pure speculation (including trend following). The investment decision and implementation may be augmented at any stage with algo support or may operate completely automatically.
A special class of algo trading is high-frequency trading, in which computers make elaborate decisions to initiate orders based on information received electronically, before human traders are capable of processing the information they observe. This has resulted in a dramatic change of the market microstructure, particularly in the way liquidity is provided. Currently, many traders use algo trading to execute fast orders in equity markets. Such trades are possible only for large transactions.
According to market sources, around 15 per cent of the commodity futures market size is executed through algo trading in India. In addition to better risk management, the guidelines should also cite the means of protecting the interest of small investors who could be affected under this automatic trading system. Since volumes in the commodity derivatives market are rising rapidly, it makes sense to have proper guidelines in this regard, they said. The stock markets regulator, the Securities and Exchange Board of India, on Friday issued guidelines for algo trading.
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“Algo trading is very risky. It’s a big challenge not only for the regulator but also for the exchanges to handle, as the market reacts based on orders executed under algo trade. The impact is fast and very hard-hitting,” said an analyst with a leading commodity broking firm.
“After the flash crash in the US in May 2010, regulators have started giving a second thought on algo trading, on stronger risk management and surveillance, due to the quick and deepening impact of such trading on the entire eco-system,” said Naveen Mathur, associate director, Angel Broking.
On May 6, 2010, US markets witnessed a flash crash. The Dow Jones Industrial Average plunged about 1,000 points or about nine per cent, only to recover those losses within minutes. It was the second-largest points swing —1,010.14 points — and the biggest one-day point decline — 998.5 points — on an intra-day basis in the history of Dow Jones Industrial Average. Traders attributed the crash to algo trading.
The regulator has brought in several reforms to enhance wider participation in the commodity futures market. Apart from ordering exchanges to mandatorily register an Investor Protection Fund Trust, it has also asked comexes to deposit all penalties collected from traders in this account for partial use in promotional activities. FMC has also intensified awareness programmes for the benefit of farmers.