How India flash crash could affect algos

Author: Ashley Lee | Published: 16 Oct 2012
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The National Stock Exchange’s (NSE) flash crash could trigger another overhaul of market rules in India, especially regarding electronic trading.

The October 5 flash crash highlighted the absence of pre-trade controls and circuit breakers on the NSE. The Securities and Exchange Board of India (Sebi) mandates these.

The Nifty index suffered enormous losses following $122 million in erroneous trades by broker Emkay Global. Although Sebi mandates that circuit breakers stop the exchange after a 10% drop, order matching at the exchange did not stop until it fell by 15.5%. Even after the orders stopped, the previously entered orders continued to execute so the market fell to nearly 19%.

“The human error by an employee of the broker was magnified by the exchange’s error,” said a Mumbai-based lawyer.

Moreover, the equity derivatives market did not stop when the equities market stopped, violating Sebi rules and imposing collateral damage on other market participants.

An in-house counsel at an international bank added that Sebi is looking at why the markets didn’t stop, which is a problem for the exchanges rather than the market participants. The NSE as well as the Bombay Stock Exchange (BSE) have both been called upon to answer questions about their circuit breakers.

Sebi will also address the exchange’s vulnerability to so-called fat finger issues, which usually happen when trades are sent directly to the exchanges using the exchange interface rather than external front-end software.

Rather than impose additional regulations, the exchanges may look towards front-end software solutions to prevent mistakes, said the counsel. He said that they may introduce confirmation pop-ups that ask whether the trader is sure of the quantity of trades if something seems out of the ordinary.

However the lawyer added that the NSE’s flash crash handling could encourage competition between exchanges, especially with the MCX-SX expected to start equity trading after Diwali. “If it is smart, it will take this as an enormous opportunity, and I’m optimistic about how its presence will make the market more competitive and less prone to problems.”

He added that he expects the other exchanges to provide investors with a more robust exchange environment following the entrance of the MCX-SX.

Effects on electronic trading

However the counsel said that it was fortunate that this wasn’t from direct market access or electronic trading. He added, “That would have opened regulations up for scrutiny, and we’re not sure what Sebi would have come back with.”

Sebi has implemented some of the world’s strictest regulations on algorithmic trading, requiring approval for individual algorithms. It would be hard-pressed to consider further scrutiny.

But the exchange’s flash crash after a trade of only $122 million raises questions about the market’s depth and its vulnerability to future errors, especially those involving electronic trading.

The lawyer said that the algorithm question is connected to the flash crash: most issues that occurred in the flash crash would apply to an erroneous algorithmic trade.

“Instead of a human punching in the wrong numbers, a badly scripted algorithm could execute a disastrous trade,” he commented.

He highlighted the recent computer glitch that affected derivatives trading on the Tokyo Stock Exchange, and noted that like other exchanges, it has a fairly black and white prescription on how to deal with erroneous trades which should be unwound.

Comparing provisions elsewhere to those in India, the lawyer said that Sebi needs more detailed rules on how exchanges deal with these erroneous trades and system improvements so this does not happen again.

A key point, however, is brokers’ insurance coverage. The counsel noted that after this incident, most brokers checked their insurance coverage. “If the flash crash cost $10 million for this particular broker, how much does that policy cover? For most brokers in the market, the policy coverage is less than $1 million.”

Instead of placing more onerous regulations on electronic trading or front-end software, the counsel added that Sebi may look at enhancing insurance coverage for brokers and ensuring it includes fat finger errors and electronic trading issues as well.

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