Cleaning the Augean stables at NSE

SEBI appears to be moving methodically to clean up NSE

SEBI appears to be moving methodically to clean up NSE
SEBI appears to be moving methodically to clean up NSE

SEBI issues notices to 14 officials at NSE

The seminal work on High Frequency Trading (HFT) and how it helped a select few prosper in the US Stock Market, titled Flash Boys by Michael Lewis hit the bookstores in 2014. The book goes into great detail on how computers co-located in the same building as the Stock Exchange server can outrun other slower systems and corner the market. I have explained how HFT can hurt common man in my post What is High Frequency Trading and How it affects you that appeared in MoneyLife in 2015. I suggest readers to read this post to understand what exactly HFT is.

It has been proven beyond doubt that by co-locating HFT’s trading systems in the same area as the Stock Exchange server, the HFT firms enjoy a distinct advantage.

On 30th May, MoneyLife wrote on their site that Market regulator Securities and Exchange Board of India (SEBI) has issued show cause notices to 14 senior officials, from National Stock Exchange (NSE) in the algorithm (algo) or high frequency trading (HFT) case. This case, a lawsuit by NSE on MoneyLife for publishing a Whistleblower letter was lost by NSE in the Bombay High Court. But NSE appealed that verdict and the case is still pending.

It has been proven beyond doubt that by co-locating HFT’s trading systems in the same area as the Stock Exchange server, the HFT firms enjoy a distinct advantage. Co-location means having the computer that does the trading in the same building (or very near) as the NSE server that is arbitrating the sale. Here is a simple example that illustrates it. While it may not be directly applicable on a one-to-one basis, it will help the reader understand the power of co-location.

Ravi and Somu are two friends who take the bus to go to the school. Ravi’s house is located right in front of the bus stop. Somu lives a few streets away and has to walk at least 10 minutes to get to the bus stop. Thanks to the vagaries of traffic, the bus may not arrive at the same time. Given this situation, who do you think has a better chance of getting on the bus every day?

Back to the situation at the NSE. SEBI has acted (finally!) and asked the senior officials to explain their algorithms and trading practices. I hope the powers that be can see the scams for what they are and start by cleaning out the Augean stables. As I suggested in my MoneyLife post, it is high time India located the NSE servers at or near the center of the country, Nagpur. Otherwise, the little investor in Trivandrum or Gangtok stands little chance of getting the trade he/ she wants. Once investor confidence erodes, it will be very difficult to bring them back. This is not going to be easy.

We should not forget the key fact for the existence of a Stock Market – it is there to provide much-needed liquidity for the needy at the right price.

In the United States, I was part of a group of dedicated investors who wanted to ensure that Brad Katsuyama’s exchange, the IEX be granted a license to operate as a Stock Exchange. IEX had installed speed bumps to ensure that all trades, be it an individual investor or an HFT firm, arrived at the same time at the exchange. After delays and sustained pressure, the SEC finally approved IEX’s application despite tremendous pushback from HFT firms, especially the one in which an ex-Fed Chairman is employed.

How would a speed bump be installed in our story of Ravi and Somu? Ravi may be required to go up and down a flight of stairs as many times as it takes for Somu to arrive at the bus stop from his house. Think of a gate that would open at Ravi’s house only after Ravi went up and down a flight of stairs 20 times.

We should not forget the key fact for the existence of a Stock Market – it is there to provide much-needed liquidity for the needy at the right price. A good first step by SEBI but it has miles to go.

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