Electronic Trading & The Indian Portrait

For many years stock exchanges were physical locations where buyers and sellers met and negotiated. Exchange trading would typically happen on the floor of an exchange, where traders in brightly colored jackets (to identify which firm they worked for) would shout and gesticulate at one another – a process known as open outcry or pit trading (the exchange floors were often pit-shaped – circular, sloping downwards to the center, so that the traders could see one another). 

With the improvement in communications technology in the late 20th century, the need for a physical location became less important and traders started to transact from remote locations in what became known as electronic trading. Electronic trading made transactions easier to complete, monitor, clear, and settle and this helped spur on its development.

By 2011 investment firms on both the buy side and sell side were increasing their spending on technology for electronic trading. With the result that many floor traders and brokers were removed from the trading process. Traders also increasingly started to rely on algorithms to analyze market conditions and then execute their orders automatically. 

The move to electronic trading compared to floor trading continued to increase with many of the major exchanges around the world moving from floor trading to completely electronic trading. 

Trading in the financial markets can broadly be split into two groups:

• Business-to-business (B2B) trading, often conducted on exchanges, where large investment banks and brokers trade directly with one another, transacting large amounts of securities, and
• Business-to-consumer (B2C) trading, where retail (e.g. individuals buying and selling relatively small amounts of stocks and shares) and institutional clients (e.g. hedge funds, fund managers or insurance companies, trading far larger amounts of securities) buy and sell from brokers or "dealers", who act as middle-men between the clients and the B2B markets

The increase of electronic trading has had some important implications:

• Reduced cost of transactions 
• Greater liquidity 
• Greater competition
• Increased transparency 
• Tighter spreads

The uneven pace of financial sector liberalization in India has been a bone of contention for some time. There have been similar disagreements about the manner in which electronic trading has been regulated. Foreign firms have entered India expecting it to be like other developing markets, but have found it much more difficult to compete effectively, facing hurdles in rolling out their services.

In a new report, the growth of electronic trading in Indian exchange-based markets, including equity, foreign exchange, and commodities. The Indian capital markets have gone through a gradual pace of liberalization. Over the last decade, steps have been put in place to allow technologies such as algorithmic trading, direct market access (DMA), and smart order routing (SOR). The country’s financial markets are poised to become international centers for electronic trading.

India's debt markets have experienced rapid growth and along with that electronic trading also risen sharply, with the market growing at a CAGR over 75% since 2005.

Technological change has increased the connectivity of participants, bringing down search costs. A new form of “hot potato” trading has emerged where dealers no longer play an exclusive role. That’s progression out there for you!

NSEL Crisis – Can We Acquit Brokers?

                                                               

Why Brokers are Equally Guilty as Defaulters? ·    They pushed investment into NSEL platform assuring higher yield following internal due diligence as eye-washer ·    Most of the brokers carried out  purchases without clients order and without securing warehouse receipt/delivery order ·    They even collected transaction charges and sales tax for stocks that didn’t exist in warehouses ·    They undertook financing activities in line of NBFC  to earned additional return on money lent ·    They enjoyed lion’s share of arbitrage profit, while NSEL received trading fee only ·     They failed from the perspective of market intelligence being either “deliberately ignorant” about the state of affairs or they simply didn’t care two hoots so longs as their earning and commissions remained intact

Unfolding of crisis at National Spot Exchange (NSEL) involving Rs. 5,600 crore of payment has certainly raised eyebrows on the functioning of very seasoned broking community who have been crying hoarse that they have been taken for a ride, while the Exchange along with its parent company and other group companies has paid a huge price for misdeeds by few key employees, brokers and handful of investors. The person who built the FT edifice has been on judicial custody while the involved key officials have been out on bail and most pertinently no question is asked to the brokers who were very actively involved in the process that led to the massive defaults. Moreover, there is no concrete action against the defaulting members even after one year. All the investors / brokers made financial gains until July 2013 when the market was halted due to government directions. However, entire blame shifted to the NSEL thereafter. Thus the current situation resembles a scenario marked with “multi-polar gain with unipolar responsibilities”.

Willful Participation in T+2 & T+25 Contracts to Make Arbitrage Profits: During 2012-13 the equity markets were not doing well and many brokers participated in T+2 & T+25 contracts to make arbitrage profits. The brokers – supposed to be experts and knowledgeable – participated in the contracts after duly assessing the risks and after exercising due diligence. They pushed investment into NSEL platform assuring higher yield to the clients/investors for higher brokerage income. Meanwhile, many brokers sold these contracts as part of portfolio management.

Funding Clients like NBFC to Earn Additional Return: Most of them also funded their clients to earn additional return on money lent, while luring the clients of 15-16% “risk free annualized return”. The brokers provided funds to their clients at 10-12%, and the clients in turn invested that money on NSEL trading platform expecting to earn 15-16%. Thus the brokers earned 10-12% as interest + 3-4 basis points commission on trades where there was 3-4% 'risk-free' spread for the investors.

Assuring Existence of Stocks in Warehouses: Besides, assuring their clients with regard to return and safety, the brokers even assured about existence of stocks in warehouses. Even several brokers visited warehouses of the borrower members for verification, but never complained to NSEL about missing/shortfall. Again, since some of the brokers were acting as C&F agents, then the onus to check stocks in the warehouse partly falls on them.

Trading without Clients’ Order & Warehouse Receipt/Delivery Order: Even at times, purchases were carried out by the brokers without clients order and even without securing warehouse receipt or delivery order.

Massive Last Minute Client Code Modifications: Again, though changing of client code was allowed on NSEL, it was observed that there were massive “last minute client code modifications” by a single brokers.

Collecting Transaction Charges & Sales Tax for Stocks that Never Existed: What’s more, they even collected transaction charges and sales tax for stocks never existed.

Hence, all brokers failed from the perspective of market intelligence being either “deliberately ignorant” about the state of affairs or they simply didn’t care two hoots so long as their earnings and commissions remained intact.

Now, they are adhering to “Head I Win; Tail You Lose” strategy to safeguard their vested interests.