Illustration: Anthony Lawrence

Domestic mutual funds and insurance companies and foreign institutional investors can stop worrying about brokers front running their orders. Front running, which is rampant in the Indian stockmarket, happens when a trader profits from information of large institutional orders. He profits from the price spurt or fall that takes place due to an institution buying or selling in a stock.

India’s stockmarket regulator Securities and Exchange Board of India (Sebi) recently gave the green signal to stock exchanges to allow direct market access (DMA) to their institutional clients. With this, an institutional investor can have the trading terminal (or terminals) of its chosen broker (or brokers) installed directly in their offices and can enter their orders directly in it. Currently, all orders in a stock exchange’s trading system have to be routed through the trading terminals of brokers and Sebi-registered sub-brokers registered with them.

In DMA, the broker’s infrastructure is bypassed. But the trade and settlement obligations — and risk management compliance involving payment of margins and exposure limits — arising from the orders and trades in the DMA terminal will continue to apply to the broker.

The DMA offers so many benefits that in the next few weeks and months, many institutional investors are likely to use DMA terminals. “We can execute our trades through the DMA and nobody can front run,” says Sanjiv Shah, executive director of Benchmark Asset Management. “Brokers can track our trades while it is happening, but their trading desk will not be privy to the trades before execution.”

DMA will also open the doors for algorithmic trading or programmed trading. More than two-thirds of the trading turnover of the New York Stock Exchange and the Chicago Board Options Exchange in the US comes from algorithmic trading. The DMA workstation can take trading data feeds coming from the stock exchange and run it through back-end computers that contain historical prices. Human-built programs then trigger off trades in the DMA.

Last year’s report of the high-powered expert committee on ‘Making Mumbai an International Finance Centre (MIFC)’ had elaborated on what algorithmic trading can do. It said, “At their simplest, algorithms can scan the spot market and the futures market simultaneously... (and respond) to mispricing within milliseconds.” Says Benchmark’s Shah, “Algorithmic trading is great for the options market because otherwise, there are so many strike prices per stock or index that it is impossible to manually monitor arbitrage or hedging opportunities on a real-time basis.”

For instance, the options market offers a chance to make profit from volatility through straddle or strangle strategies. In a strangle, you buy a call and a put of different strike prices to make profit from volatility at the lowest premiums possible.

The complexity and the range of the market actually helps program trading. NSE’s equity derivatives market has more than 9,000 options contracts, ideally suited for program trading. The MIFC report was confident that “the human manager with such an auto-quote system (algorithm with DMA) infuses liquidity into a vast array of options...” While program trading infuses liquidity, it can sometimes trigger market crashes — such as the one in 1987 in the US, but program trading has become much more sophisticated since then.

The DMA is among the first few major and bold steps taken by Sebi’s new chairman, C.B. Bhave. An earlier step had the institutional investors grumbling about having margins imposed on their trades in the cash market. The DMA now gives them something to feel good about. Sebi has given institutional investors the freedom. Whether they misuse it through program trading, only time will tell.

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(Businessworld issue 15-21 April 2008)