The Securities and Exchange Board of India (Sebi) is considering
a proposal to impose a congestion charge to curb algorithmic traders
who send large numbers of order messages to stock exchanges. If it isn’t
implemented carefully, the market regulator will be playing with fire. A
wrongly calibrated message fee can impact liquidity and increase
bid-ask spreads, and will hurt the very investors Sebi is trying to
protect.
But first, the congestion fee proposal, or any regulation
for that matter, begs the question: What market failure is the
regulator trying to address? According to a person familiar with the
regulator’s thinking, the congestion charge is similar to a traffic tax
that seeks to reduce congestion on roads.
Some algorithmic traders
send a large amount of orders to exchanges, which are later either
cancelled or modified, and don’t end up in actual trades. The case for a
congestion fee, according to this person, is to disincentivize traders
who clog exchange systems with a disproportionately high amount of
orders. After all, high-message traffic necessitates higher investments
by exchanges for enhancing trading infrastructure and surveillance
capacity, and imposes costs on other market participants and the
regulator as well. As such, it makes sense for such costs to be borne
proportionally by those who are imposing these burdens on the
marketplace. A message fee fits well in this scheme of things.
The Australian Securities and Investments Commission (Asic) has charged market participants a message fee for years now,
although the clearly stated intent there has been to recover its market
surveillance costs. A drop in order-to-trade ratios has been one of the
fallouts of Asic’s move, although this was more of a by-product. Its
cost recovery fee is calibrated at levels that help it meet its budget
for market surveillance.
To start with, Sebi would do well to
articulate the regulatory intent behind the congestion fee clearly. It
needs to state where order-to-trade ratios are at currently, how it
compares with other markets, and why it sees them as detrimental to the
market.
And importantly, it needs to provide a cost-benefit
analysis of the proposed congestion fee. Market-making firms that use
algo-trading tools are quick to point out that such fees will invariably
impact firms that provide liquidity to the markets. Market makers aim
to provide two-way liquidity, while at the same time maintaining low
inventory levels. If the market moves against them, they are among the
quickest to cancel existing orders in the system.
If the
regulator sets a message fee at a level that is seen as unviable by some
traders, many of them would think twice about posting passive orders
which can potentially be cancelled at a later stage. The firms that
continue with market-making activities will demand higher spreads, which
will hurt all investors. If things turn out this way, Sebi’s move will
be counterproductive.
Clearly, the message fee needs to calibrated
in a way that it doesn’t impede market makers who provide much-needed
liquidity to the markets. Currently, Indian exchanges penalize traders
whose order-to-trade ratios are higher than certain prescribed limits
such as 50:1. But while calculating the ratio, exchanges exclude orders
that are placed within a +/- 1% range from the last traded price. The
aim behind this is to support market makers and penalize only those
traders who unnecessarily clog exchange systems with orders that are
unlikely to get executed.
Should Sebi consider a similar system
with the message fee? Venkatesh Panchapagesan, associate professor,
finance and accounting, at IIM Bangalore says that a 1% range applied to
all stocks may not be effective in curtailing high messaging traffic,
something he finds in a study he
did with researchers at Indira Gandhi Institute of Development
Research. According to him, the fee should be levied based on the
volatility of a stock/index, so that only genuine liquidity providers
are excluded. The regulator could also consider excluding passive orders
if they had remained exposed for a finite period of time, he adds.
The
silver lining in the latest algo-trading proposal is that it isn’t as
bizarre as, say, the two-queue proposal Sebi flirted with for years to
bring parity between sophisticated traders and sophisticatd traders.
But even with the congestion fee, things can quickly get out of hand,
if it’s not implemented carefully. After having thought about
algorithmic trading regulation for years now, hopefully Sebi won’t let
us down.
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