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Thoughts on high frequency trading after SEBI took on Jane Street

In recent days, the ban on Jane Street has re-ignited discussions on scams and the much-scammed retail trader. Much of this follows a familiar script – either blame SEBI, or the foreign manipulator, or inadequate regulation.

And as usual, everyone, including politicians of all hues, is commiserating with the hapless small investor.

Let’s step back for a moment– why do retail punters, folk like you and me – need to be in this game at all?

In markets, retail traders have always lost out to the sharks. It is a fairy tale that small traders can beat (or even match) the big fish. In investing, we may have a chance – but in trading, the odds are hugely stacked against us.

Today, the game is all about technology. Once upon a time, there were tickers and charts – read by humans – and instinct and experience played a big role.

Then came computers and charting software, and then various types of tools that helped spot patterns… and these multiplied by the hundreds, given the complexity and variety of the patterns. Now we have “algos” or powerful algorithms able to process a zillion variables and trade in nanoseconds. And getting more powerful and intelligent every day.

Traders are locked in an endless battle – my algo versus your algo, my hardware vs yours, my latency versus yours (recall the NSE co-location mishap). And of late, my AI versus your AI. Or my chip versus your chip.

In the middle of this onslaught, the hapless retail punter, lured by free brokerage and easy financing, provides the fuel for all of this. Think of it as a huge whale (or several such, and throw in some sharks as well) swallowing thousands of small fish every time they open their mouths.

SEBI is trying to think up ways to protect the hapless retail punter. Most ideas include restrictions on trading volumes or access or such like. But this will not alter the basic dynamic. The algo sharks will still win.

Maybe, just maybe… we should think of something more radical.

Why not simply ban algos, or high frequency computerized trading (HFT)?

An estimated 60% (or more) of trading volumes on Indian exchanges are now accounted for by high frequency trading. But what value does this create? How do computer programs competing against each other contribute to the economy, or to the planet, or to anything at all?

The only winners are the intermediaries – brokers, exchanges and of course, the sharks and whales.

I understand the argument that such trades contribute to liquidity, and reduce transaction costs for the rest of us. But how far does this argument take us? How much liquidity do we really need? Do a few basis points (smaller tick sizes) really help returns for a long term investor?

In any case, the algos are focused on a few high-volume counters or indices – in fact, in places where high volumes allow them to stay hidden!

I know this is quite a drastic suggestion. I should clarify that I’m not a leftist, and I fundamentally believe that equity markets are core to a healthy economy. However, this algo thing seems to have gone haywire.

Why do we need a system where computers are working against you and me to make money?

Or are we simply aping the US markets, believing that their way of doing things must always be right?

Think about it for a while.