Futures

Monday, October 04, 2010

No evil algo-trader behind the flash crash

Posted by Giles Nelson

The long anticipated joint SEC and CTFC report on the 6 May 2010 flash-crash came out last Friday.

After reading much of the report and commentary around it, I'm feeling rather underwhelmed.

The root cause of the flash-crash, the most talked about event in the markets this year, was a boring old "percentage-by-volume" execution algorithm used by a mutual fund to sell stock market index futures. How banal.

The algorithm itself was simple. It just took into account volume, not price, and it didn't time orders into the market. Many commentators have pejoratively described this algorithm as "dumb". It may be simple, but it's one of the most common ways that orders are worked - buy or sell a certain amount of an instrument as quickly as possible but only take a certain percentage of the volume available so the market isn't impacted too much. The problem was the scale. It was the third largest intra-day order in the E-mini future in the previous 12 months - worth $4.1Bn. The two previous big orders were worked taking into account price and time and executed over 5 hours. The flash-crash order took only 20 minutes to execute 75,000 lots.

It wasn't this order on its own of course. Fear in the markets created by the risk of Greece defaulting was already causing volatility. Stub quotes (extreme value quotes put in by market makers to fulfill their market making responsibilities) appear to have contributed. There was the inter-linking between the futures market and equity markets. There was the very rapid throwing around of orders - described as the "hot potato" effect, certainly exacerbated by the many high-frequency traders in the market. There was the lack of coordinated circuit breakers in the many US equity markets. There was the lack of any real-time monitoring of markets to help regulators identify issues quickly.

High-frequency and algorithmic trading have been vilified in many quarters over the last months. I think many were expecting that the flash-crash cause would be a malignant algo, designed by geeks working in a predatory and irresponsible hedge fund, wanting to speculate and make profits from "mom and pop" pension funds. It just wasn't anything of the kind.

The flash crash has raised important issues about the structure of multi-exchange markets, the role of market makers, the lack of real-time surveillance and how a simple execution strategy could precipitate such events. I do hope that the findings in the flash-crash report will ensure a more balanced view on the role of high-frequency and algo trading in the future.

Monday, September 27, 2010

Mystery Solved, but Questions Remain

Posted by John Bates

Scooby Doo and the gang have been investigating the spooky mystery of the "phantom orders" on CME and they found out that the culprit was... wait for it.... The CME! Turns out the exchange plugged in some new contracts to try them on for size and they mistakenly went live and bam! they got traded.

According to the FT, CME Group said it had “inadvertently” posted test orders intended for its quality assurance procedure on Globex (http://tinyurl.com/23bpfjj). CME said the company tests its systems as a matter of course and it had not determined whether human error or a computer glitch caused the mistake.

The FT said the mistaken order flow began at 3:38pm ET time on Monday, September 13th and lasted for six minutes. Futures brokers noticed oddly anomalous spread price activity during that period, when trading is usually slow.

CME said it was working with the customers that somehow managed to trade these contacts in those six minutes, and says it won't "bust" the transactions. Fair enough. But the mistake shows how the exchange lacked adequate monitoring technology to see that some test contracts had entered the live environment - and were being traded.

This six minute phantom orders mystery is solved, but the very fact that it occurred supports my argument that brokers, traders and exchanges need to have more advanced capabilities to detect problems and abuse as they happen, and recommend actions to take in response. The Mystery Machine got to the bottom of the case, but it was not fitted with the latest real-time surveillance equipment. It seems, like Velma, the CME temporarily lost their glasses!

Wednesday, September 15, 2010

I Would’ve Got Away With It Too - It If It Wasn’t for You Pesky Kids….

Posted by John Bates

Strange things are happening in the markets! As you know if you’ve been following this blog, quite a few scares, horrors and apparitions have been sighted in equities, futures, FX and oil markets over the last few months. But fortunately the Mystery Machine has rolled into town and Scooby, Shaggy and the gang are investigating…

 

The latest spooky mystery is “phantom orders” that appeared to scare participants on the CME (read more about it here). For 6 minutes on Tuesday unexplained orders, that could have been caused by a “fat finger” error or an “algo gone wild”, caused CME to use Rule 587 which gives them powers “including without limitation, closing the market, deleting bids and offers, and/or suspending new bids and offers”. So although they weren’t sure what was going on – the CME were at least able to respond.

 

Another report this week shows how those involved in alleged market abuse are starting to be unmasked. Last week I wrote a blog posting called “Algos Can Get Stuffed” which was also featured on the Tabb Forum. In it I talked about the possibility of firing orders into the market with the intention of misleading the market or slowing the market down – and even how some link this phenomenon with the flash crash. This week a trading firm called Trillium was fined by FINRA for using illegal trading practices (read more about it here).  Trillium was fined $1m for sending orders aimed at deceiving investors. Nine traders entered buy and sell orders in patterns that aimed to manipulate the prices of instruments. And they did this 46,000 times! This “layering” enabled Trillium to trade at a profit once they’d manipulated the price.

 

These 2 incidents show that awareness of the problems we’ve been writing about on this blog have increased radically. Trading venues are more aware that algos gone wild and fat fingers can cause market panics and manipulate prices. Regulators are more aware that high frequency trading can be used as a weapon for market manipulation.

 

But we can’t rest on our laurels. Maybe we got lucky this time. As market data volumes continue to increase we need to have more advanced capabilities to detect problems and abuse as it’s happening, and recommend actions to take in response. Let’s ensure the Mystery Machine is fitted with the latest real-time surveillance equipment. Let’s enable the gang to unmask more villains at the haunted “high frequency manor” inspiring the legendary outburst of “I would’ve got away with it if it wasn’t for you pesky kids….”

Wednesday, September 08, 2010

Algos can get stuffed!!

Posted by John Bates

As regulators continue to look into the causes of the May 6th flash crash, some high frequency trading approaches are coming under scrutiny. In particular the concept of “quote stuffing”, where algorithms send so many orders into the order book that the market cannot possibly respond, has come under fire from market participants and the press.

 

The SEC, having reportedly decided that quote stuffing probably did not have a major role in the flash crash, is now taking aim at the practice to see if it puts some investors at a disadvantage by distorting stock prices (http://tinyurl.com/264kr3o). The CFTC is looking at data from database developer Nanex and mulling how to address quote stuffing in futures markets (http://tinyurl.com/3a7w7sv).

 

Meanwhile, concerning incidents continue to happen in the market. As recently as last week there was an incident that caused Christopher Steiner at Forbes to write a story called “Did we dodge another flash crash on September 1st?” The story describes how on September 1st at 10am quote volumes ballooned - as they did on May 6th. In fact quotes reached 275,000 per second, as opposed to 200,000 on May 6th. Unlike the flash crash though there wasn’t a dramatic fall in prices. However, the bids and offers did cross for a time – leading to high frequency traders taking advantage of arbitrage opportunities. This data was exposed again by firm Nanex – and left the market wondering if quote stuffing by high frequency traders was behind the spikes.

 

The world is waking up to the fact that high frequency and algorithmic trading have quietly become part of the market fabric, and the world does not seem to be too happy about it. HFT and algorithms are being "demonized" said the FT article, and I agree. I also think the hype is overblown.

 

Once trading became automated, trading strategies naturally morphed to take advantage of the available technology and higher speeds. High frequency statistical arbitrage techniques can also mean more order cancellations, some of which may - wittingly or unwittingly - fall into the quote stuffing category. Those involved in intentional quote stuffing as a strategy need to be held to task. But to demonize all strategies or call for banning them is a step backward. What is needed is a framework by which to police them - and to prevent them from going wrong. The technology to do this is already available. For example, an area I’ve had a lot of experience in is the use of complex event processing to provide a platform for high frequency, multi-venue market surveillance. With such a system quotes can be monitored to determine how many quotes per second there are on each ticker symbol, the ratio of quotes to trades, when large spikes are emerging and many other interesting real-time analytics and patterns that it’s useful to track in real-time.

 

But regulation of high speed trading practices has fallen short to date. Regulators have not had the funds, the technology, the power or the expertise to follow and control high speed trading. However, it is good to see that progress is now being made. CFTC commissioner Bart Chilton wrote last week in an article entitled Rein in the cyber cowboys: “There may be some cyber cowboys out there and they could be giving respectable traders a bad name”. His colleague CFTC commissioner Scott O'Malia told Reuters last week that, if traders are flooding the market with orders with the intention of slowing others down, the regulator would consider addressing quote stuffing under new rules in the financial regulation bill that deal with disruptive trading practices.

 

It is possible that quote stuffing is causing more problems that just slowing down the natural flow of trades. Trading behavior patterns suggest that these quotes are a distraction to other traders. There are patterns evident where the quote "stuffer" continuously traded first - possibly by distracting others. And the disruption can cause the bid and offer to cross – providing a nice arbitrage opportunity for those who are not distracted! All of this needs to be looked into further. I fully support the CFTC and SEC's efforts to get to the bottom of not just the flash crash, but HFT and algorithmic trading practices. They are now integral in the equities and futures markets, and increasingly so in FX, fixed income and energy. What we need is better policing of the markets to protect the honest ranchers from the cyber cowboys.

Tuesday, August 31, 2010

Taming the Wild Algos

Posted by John Bates

"And now," cried Max, "let the wild rumpus start!"

— Maurice Sendak: Where the Wild Things Are

 

It’s not just equities and futures markets where strange stuff happens! An “algo gone wild” was spotted in the oil market (it actually happened earlier this year) and intrepid Reuters journalists got to the bottom of it.

 

High frequency trading firm Infinium Capital Management is at the center of a six-month probe by CME Group (and reportedly the CFTC) into why its brand new trading program malfunctioned and racked up a million-dollar loss in about a second, just before markets closed on Feb. 3. The algorithm, which was brand new, went live 4 minutes before the end of trading. It fired in 2000-3000 orders per second before being shut off. The oil price surged $1 then slid $5 over the course of the next two days. Read about the full story here:

http://www.reuters.com/article/idUSTRE67O2QQ20100825

 

I know the CEO of Infinium Chuck Whitman from the CFTC technology advisory committee – he’s a good guy and very knowledgeable. I believe him when he says his wild algos had no malicious intent – the algos were just broken and shouldn’t have been put live.

 

With algorithms and HFT comes the possibility of mistakes. Many more firms outside of the equities world are embracing HFT and their inexperience can cause market disruptions such as the Feb 3rd CME issue. A flash crash in oil or other commodities - or even foreign exchange - is not to be scoffed at. In fact, many commodities markets are much less liquid and homogenous than equities, and can be even more vulnerable to mistakes or manipulation. In the case of Infinium, the algo caused a spike in trading volumes by nearly eight times in less than a minute. It was a classic case of the algo running wild until it faltered and 'choked'. This is not how HFT strategies are supposed to work.

 

There are a number of best practices that can be used to mitigate against algos going wild:

 

The first best practice is diligent backtesting – using historic data and realistic simulation to ensure many possible scenarios have been accounted for. What does the algo do in a bull market, a bear market, at the open, at the close, when unexpected spikes occur, during a flash crash, when non-farm payrolls or other economic news is released etc. etc.? Of course there’s always the possibility of a “black swan” scenario – but then there’s always the possibility of an earthquake in London – but I bet the buildings aren’t built to withstand one – it’s a matter of covering likely possibilities as best you can. A backtesting process needs to be streamlined of course – as short time to market of new algos is key.

 

A second best practice is building a real-time risk firewall into your algo environment. Just like a network firewall stops anomalous network packets reaching your computer, so the risk firewall should stop anomalous trades getting to trading venues. These anomalous trades might be human or computer generated – such as “fat finger” errors, risk exposures (for a trader, a desk or an institution) being breached, or even algos gone wild (e.g. entering spurious loops and spitting out anomalous orders). Real-time risk monitoring is a second level protection for those problems you don’t catch in backtesting.

 

A third best practice is to use real-time market surveillance in your algo environment. Even if trades do not breach risk parameters, they may breach compliance rules, regulations or may be perceived by a regulator as market manipulation (by accident if not design). Detecting these patterns as they happen enables good internal policing by trading firms, rather than investigation or prosecution by regulators.

 

An algorithm is a tool in a trader's toolkit, and it needs to be taken care of as such. If it is well-oiled and the trader or quant or risk manager monitors its progress then the algo will do its job quickly and nicely. If the trader/quant/risk manager doesn’t properly prepare the algo or ignores the algo and lets it get rusty, so to speak, it could lose its edge and run amok. Algorithms must be monitored constantly for performance and for errors, and sometimes tweaked on-the-fly to ensure best results. A good algorithmic trading platform will enable trading firms to do just that.

 

Trading firms are not the only ones who need to be on guard for possible algos gone wild. In the case of Infinium, the regulators and the exchange were also slow on the uptake. This shows that everyone needs to be proactive in using the correct tools to monitor algorithmic trading. Sensing and responding to market patterns before the aberrations or errors have a chance to move prices is the right thing to do - in all asset classes. Be like Max and tame the wild things!

Thursday, August 26, 2010

The Risks of Being Caught Naked

Posted by John Bates

According to the FT, the Financial Industry Regulatory Association is undertaking a “sweep” of broker-dealers that offer direct market access to high-frequency traders to find out if they have pre-trade risk management controls in place for their algorithmic customers. (Read the full story here: http://tinyurl.com/28rg287). Here at Progress Software we have been advocating the use of pre-trade risk management tools for some time. The prospect of High Frequency Trading (HFT) firms running trades directly through broker algorithms (naked access) to exchanges/ECNs without adequate supervision has always concerned us. Brokerage firms simply give their clients an exchange ID number, which the clients then enter into their algorithms so that they can trade directly with the exchange.

Regulators are right to be concerned. Unfiltered access to trading destinations can end up causing trading errors or worse. Anything can happen with naked access; from fat fingered errors, trading limits being breached, even fraud - all of which can cost brokers, traders and regulators big money.

Although the SEC proposed banning naked access in January, and the Committee of European Securities Regulators (CESR) is likely to follow in its footsteps, there has been considerable pushback from brokers and trading firms. They say that adding a pre-trade risk management step would cause a "latency hop" in the trading process, claiming it would make them uncompetitive.  A layer of risk management often adds a third party into the mix, and - consequently - a delay.

But if everyone is required to add real-time, pre-trade risk management, then the competitive disadvantage is moot. The benefits of being able to pro-actively monitor trades before they hit an exchange or ECN far outweigh any microscopic latency hops in any event. The naked access playing field is hardly level. There are trading systems out there that claim to throughput a trade in 16 microseconds from outside an exchange's firewall, while exchange and ECN systems range anywhere from 250 to 700 microseconds (according to measurements by latency management firm Corvil).

Latency is clearly an important issue and complex event processing offers a solution. Brokers can achieve ultra-low-latency pre-trade risk management without compromising speed of access.  An option is a low latency "risk firewall" utilizing complex event processing as its core, which can be benchmarked in the low microseconds.  With a real-time risk solution in place, a message can enter through an order management system, be run through the risk hurdles and checks, and leave for the exchange a few microseconds later.

It is the ideal solution to a tricky question - how do I manage risk before my trade hits the exchange without compromising speed? The benefits are clear - a latency hop of a few microseconds not only saves money, it can also prepare your firm for the regulatory future.

Monday, August 23, 2010

Evacuate the Dancefloor

Posted by John Bates

Looking for all the world like someone yelled "fire" in a crowded nightclub, prop and quant traders are stampeding out of investment banks and headed for the hedge fund world. Some, mainly the prop traders, are being pushed gently out the door as banks prepare for the Volcker Rule (http://tinyurl.com/39ap28d). Others, like the quants (http://tinyurl.com/23c5h6d), are in search of the mega-bonuses that their prop trader or hedge fund manager compatriots are (or were) getting.

 

Impending changes in regulation are prompting banks to spin off proprietary trading activities, many by expanding their operations overseas where Messieurs Dodd and Frank cannot reach them. I’m very concerned about this “regulatory arbitrage” in which firms may move away from the US to find less strict regulatory regions. We don’t want to lose the lead in this important area of the economy.

 

Spin offs and regulatory arbitrage may well leave a herd of US traders looking for work and many may end up working at - or starting - hedge funds. The quants, having slaved over hot computers for the last few years to line bankers' pockets, are forming their own trading companies or joining prop trading firms with a profit-sharing deal.

 

Most of these traders will be in for a rude awakening when they sit down to work. Prop traders joining hedge funds will find that the technology budgets may not be as generous as they were at their last bulge bracket employer's firm. The quants, who are essentially programmers, will face huge challenges in finding firms that have the kind of low latency, scalable architecture that they need to design, tweak and trade with their algorithms. The level of trading freedom is different, too. Hedge fund managers will have something to say about a trader's profits - or lack thereof. Quants may find that designing an algorithm and handing it over to the trading desk is not quite the same as being responsible for the profits that the algo makes - or doesn't make.

 

Make no mistake, these prop traders and quants are highly intelligent and adaptable people. There will be many challenges to face going forward, but technology need not be one of them. There are instantly useable, scalable platforms that quants and hedge funds can use to build and deploy algorithms. These platforms, such as Progress Apama's Complex Event Processing Platform, offer a robust technology infrastructure to successfully create, test, deploy and manage their algorithmic strategies.

 

Algorithmic trading software is constantly transforming. As the volume of real-time market data continues to increase, algorithmic trading solutions demand an infrastructure that can respond to market data with near zero latency. To trade effectively in competitive markets requires rapid, opportunistic response to changing market conditions before one's competition can seize those opportunities. The people that are running for the doors and into the arms of hedge funds or other trading firms, will need this advantage. Competition is fierce, and their previous employers already have the technology advantage.

Thursday, August 12, 2010

The Busy "B" in BRICS

Posted by John Bates

Here in the United States algorithmic and high frequency trading have been under fire lately, blamed for everything from the May 6th flash crash to ruining small investors' profit margins. In the rest of the world, however, algorithmic trading is being recognized as both an opportunity and a way to attract liquidity and it is starting to blossom.

 

Exchanges in several emerging nations are getting with the electronic trading program - many by doing cross-listing (and even cross-ownership) deals with some of the larger, more automated exchanges. As Jeremy Grant put it in an article for the FT: "You scratch my back, and I’ll scratch yours." (see link here: http://www.ft.com/cms/s/0/123ece18-99ad-11df-a852-00144feab49a.html). Eurex and the CME have done many such deals recently, spanning Brazil, Malaysia, India, South Korea and Mexico. It makes sense for both parties - the big exchanges get exposure to new markets, and the smaller ones get to take advantage of the electronic expertise of the larger ones.

 

Brazil was one of the first to get on board when Brazilian Securities, Commodities and Futures Exchange (BM&FBovespa) was created by the merger of Brazil’s derivatives and stock exchanges in May 2008. Of all the BRICs (Brazil, Russia, India and China) Brazil is the real busy bee. In June 2009 the BM&F closed its “open outcry” pits in favor of an all-electronic GTS trading system (already introduced by Bovespa in 2004). The same month, the exchange joined the global trend to “co-location”, allowing customers to install servers inside the exchange’s data centers, ensuring low-latency for high-speed automated trades. These two moves set up BM&FBovespa as a destination that attracted algorithmic trading like bees to honey. The big banks are flocking in - Bank of America, UBS and Goldman Sachs have already announced the availability of algorithmic trading in Brazil. And an avalanche of brokerages have geared up with technology to enable algorithmic trading for their customers.

 

Brazil’s appetite for automated trading – particularly high-speed, low-latency algorithmic trading – remains very keen. Progress Software is excited to be part of this growth story. In February 2009, Ágora Corretora, one of Brazil’s largest brokerages, offered custom algorithmic trading strategies to its buy-side clients, through Progress Software’s Apama algorithmic trading platform. Around the same time another Brazilian brokerage, Alpes Corretora, deployed the same Apama algorithmic trading to develop and deploy execution arbitrage strategies for futures and equities.

 

Since mid 2008, over twenty Brazilian banks and brokerages rushed to make the switch from manual to electronic trading using Progress Apama’s algorithmic trading platform. These also include FinaBank Corretora, Banco Fator and most recently Link Investmentos, which bought in Apama’s algorithmic trading platform in March 2010. And many of these large banks are now offering their buy-side clients the chance to fine-tune their already customized algorithmic trading strategies, as per in Europe and the US. (It’s worth noting Apama also has direct buy-side clients.) Our Brazil success story has much to do with the fact that Progress is still the only capital markets-focused technology provider with an established local presence in São Paulo, Brazil, offering customizable technology.

 

BM&FBovespa will doubtlessly continue to incentivize both local institutions and international investors. The exchange’s tie-ups with CME and Nasdaq OMX Group will continue to drive new business growth in Brazil this year and into 2011. And the introduction of co-location at the Bovespa will further boost algorithmic trading both locally and internationally.

 

Brazil has been an incredibly exciting success story for Progress and our customers over the last 2 years. Now other firms are beginning to sit up and take notice of the region! But Progress was there first; we’ve gathered huge experience in the region and we remain ready and willing to provide more new customers with the ability to deploy and customize algorithmic trading solutions.

 

So Brazil is busy ‘B’! I’m looking forward to reporting more on the RICs in BRICs soon.

Wednesday, August 04, 2010

Algorithmic Terrorism

Posted by John Bates

At the CFTC's first Technology Advisory Council meeting on July 14, there was concern expressed around the concept of quote-stuffing. There was some evidence presented that the May 6th flash crash may have been caused by or exacerbated by this activity. While with regard to the flashcrash, other market experts I’ve spoken to know dispute this was the cause, quote-stuffing is a topic worthy of discussion

 

At the CFTC meeting, where I was an invited participant, data was presented from trade database development firm Nanex, which suggested quote stuffing contributed to the destabilization on May 6th. In this case the data suggests huge numbers of quotes were fired into the market on particular symbols (as many as 5000 per second) and that many of these were outside the national best bid/offer (NBBO). So what’s the point of this? Well with latency as a key weapon, one possibility is that the generating traders can ignore these quotes while the rest of the market has to process and respond to them – giving an advantage to the initiator. Even more cynically one can consider these quotes misleading or even destabilizing the market. In fact, Nanex state in their paper: "What we discovered was a manipulative device with destabilizing effect". Quote stuffing may be innocent or an honest mistake, but Nanex's graphs tell a very interesting tale (http://www.nanex.net/FlashCrash/CCircleDay.html). There are patterns detected - on a regular basis - that one could conclude is quote stuffing for the purpose of market manipulation. There's a very good article by Alexis Madrigal that discusses the research and issues in more detail (http://www.theatlantic.com/science/archive/2010/08/market-data-firm-spots-the-tracks-of-bizarre-robot-traders/60829/).

 

At the extreme, quote-stuffing could operate like a “denial of service attack” – firing so many orders that the market can’t cope - and crippling the trading of certain symbols, certain exchanges or the whole market. An influx of orders in sudden bursts to one exchange on one stock can slow down that system as it tries to process these orders. Nanex notes that there are 4,000 stocks listed on the NYSE and nine other reporting exchanges in the U.S. If each reporting exchange for each stock quoted at 5,000 quotes per second it would equal 180.0 million quotes per second. A daunting task no matter how advanced their processing technology is.

 

Without trying to overstate the issue, in the most extreme circumstances these practices could be considered algorithmic terrorism. One can imagine how, at the extreme, it is potentially catastrophic. The concern is that a well-funded terrorist organization might use such tactics in the future to manipulate or cripple the market. So much of our economy is underpinned by electronic trading – so protecting the market is more important than guarding Fort Knox! Regulators, such as the CFTC and SEC are taking this seriously - and need to respond.

Thursday, July 22, 2010

India – big potential for algorithmic trading

Posted by Giles Nelson

I spent last week in India, a country that, by any standards, is growing fast.  Its population has doubled in the last 40 years to 1.2B and economic growth has averaged more than 7% per year since 1997.  It’s projected to grow at more than 8% in 2010. By some measures, India has the 4th biggest economy in the world. 

Progress has a significant presence in India. In fact, people-wise, it’s the biggest territory for Progress outside the US with over 350 people. Hyderabad is home to a big development centre and Mumbai (Bombay) has sales, marketing and a professional services team.

The primary purpose of my visit was to support an event Progress organised in Mumbai on Thursday of last week on the subject of algorithmic trading. It was also our first real launch of Progress and Apama, our Complex Event Processing (CEP) platform, into the Indian capital markets. We had a great turnout, with over 100 people turning up. I spoke about what we did in capital markets and then participated in a panel session where I was joined by the CTO of the National Stock Exchange, the biggest in India, a senior director of SEBI, the regulator, and representatives from Nomura and Citigroup. A lively debate ensued.

The use of algorithmic trading is still fairly nascent in India, but I believe it has a big future. I’ll explain why soon, but I’d like first to give some background on the Indian electronic trading market, particularly the equities market, which is the largest.
 

The market
India has several, competing markets for equities, futures and options, commodities and foreign exchange too.  In equities, the biggest turnover markets are run by the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE), with market shares (in the number of trades) of 74% and 26% respectively. Two more equity exchanges are planning to go live soon – the Delhi Stock Exchange is planning to relaunch and MCX is also currently awaiting a licence to launch. This multi-market model, only recently adopted in Europe for example, has been in place in India for many years.

It was only two years ago that direct market access (DMA) to exchanges was allowed. Although official figures don’t exist, the consensus opinion is that about 5% of volume in equities is traded algorithmically and between 15% and 25% in futures and options. Regulation in India is strong - no exchange allows naked access and the BSE described to me some of the strongest pre-trade risk controls I’ve come across - collateral checks on every order before they are matched. The NSE has throttling controls which imposes a limit on the number of orders a member organisation can submit per second. Members can be suspended from trading intra-day if this is exceeded. The NSE also forces organisations who want to use algorithms to go through an approval process. I’ll say more about this later. Controversially, the NSE will not allow multi-exchange algorithmic strategies so cross-exchange arbitrage and smart-order routing cannot take place. Lastly, a securities transaction tax (STT) is levied on all securities sales.

So, with the above restrictions, why do I think that the Indian market for algorithmic trading has massive potential?
 

The potential
The Indian market is very big. Surprisingly so to many people. Taking figures from the World Federation of Stock Exchanges (thus I’m not counting trading on alternative equity venues such as European multi-lateral trading facilities), the Indian market, in dollar value, may still be relatively modest – it’s the 10th largest. However, when you look at the number of trades, India’s the 3rd largest market, only beaten by the US and China. The NSE, for example, processes 10 times the number of trades as the London Stock Exchange. So why isn’t more traded in dollar terms? That’s because trade sizes on Indian exchanges are very small. The median figure worldwide is about $10K per trade. The figure in India is about $500 per trade, a 20th of the size. In summary, surely the task of taming the complexity of this number of trades and the orders that go with them is ideal for algorithmic trading to give an edge? To compare to another emerging, “BRIC”, economy, that of Brazil, where the number of firms using Apama has gone from zero to over 20 in as many months, the dollar market size is fairly similar but the number of equity trades in India is 33 times more. The potential in India is therefore enormous.

India is already there in other ways. All exchanges are offering co-location facilities for their members and debate has already moved on to that common in more developed markets on whether this gives certain firms an unfair advantage or not and whether co-location provision should be regulated.

 

The challenges
There are some difficulties. The STT is seen by some as an inhibitor. However, its effect is offset somewhat by the fact that securities traded on exchange are not subject to capital gains tax. 

The NSE process for approving algorithms is more controversial. Firms that want to algorithmically trade must show to the NSE that certain risk safeguards are in place and “demonstrate” the algorithm to the exchange. As the biggest exchange, the NSE wields considerable power and thus its decision to vet algorithms puts a brake on market development. I believe this process to be unsustainable for the following reasons:

  1. As the market develops there will simply be too many algorithms for the NSE to deal with in any reasonable timeframe. Yes, India is a low-cost economy, but you need highly trained people to be able to analyse algorithmic trading systems. You can’t simply throw more people at this. Firms will want to change the way algorithms work on a regular basis. They can’t do this, with this process in place.
  2. It raises intellectual property issues. Brokers will increasingly object to revealing parts of their algorithms and their clients, who may want to run their alpha seeking algorithms on a broker-supplied co-location facility, will most definitely object. 
  3. It puts the NSE in an invidious position. Eventually an algo will “pass” the process and then go wrong, perhaps adversely affecting the whole market. The NSE will have to take some of the blame.
  4.  Competition will force the NSE’s hand. The BSE is trying to aggressively take back market share and other exchanges are launching which will not have these restrictions.

It strikes me that the NSE should spend its efforts into ensuring that it protects itself better. Perhaps a reasonable comparison is a Web site protecting itself from hacking and denial of service attacks. If they can do it, so can an exchange. And it would offer much better protection for the exchange and the market in general.
 

In conclusion
I’m convinced of the growth potential in India for algo trading. The market is large, the user base is still relatively small and many of the regulatory and technical prerequisites are in place. There are some inhibitors, outlined above, but I don’t think they’ll hold the market back significantly. And finally, why should India not adopt algo trading when so many other, and diverse, markets have?

Progress has its first customers already in India. I look forward to many more.