Gaming an outdated system is not necessarily illegal in India

While the Sebi move aims to protect market fairness and retail investors, its regulatory action seems delayed. This is not only in the current case of Jane Street, but, more worryingly, in addressing systemic flaws in our otherwise well-regulated trading markets and the inadequacy of tech-based safeguards to check potential market abuse by algorithmic trading firms.

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Internationally, New York-based Jane Street is seen as a leader in this narrow speciality of algo trading, ahead of the likes of Goldman Sachs, Citadel,Virtu, SIG, etc. Classmates and market experts confirm that Jane Street’s interview process for recruitment is truly gruelling. It involves a series of games (primarily card games) played by interviewees against each other that call for the use of probability theory. It is rumoured that the now-disgraced and convicted (but brilliant) Sam Bankman-Fried of FTX had beaten everyone else for a coveted spot in Jane Street’s trading internship programme.

Though the jury is out, I find it difficult to believe that international algorithm-using high-frequency trading (HFT) institutions would violate rules so blatantly. From all that I have read, there seems nothing illegal per se with the Jane Street modus operandi, although a wider understanding how options and cash markets work, particularly on expiry dates, appears scarce. Incidentally, this sort of price action occurs on ‘triple witching’ or ‘quad witching’ expiry dates in US stock markets too, except that the presence of a large number of sophisticated players—on both sides—tends to mute the market impact.

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Unless Jane Street and its associates were acting in concert with non-related entities, there is no legal bar against a market player buying a large volume of stock and dumping it within hours. This induces a spike (and collapse) in the ‘implied volatility’ of the underlying options. But that is the nature of the beast we have nurtured in our globalized capital markets. I don’t believe we have any regulation to prevent pump-and-dump strategies unless an ‘intent’ to manipulate markets is proven.

In the absence of position limits laid down by regulation, merely causing a disproportionate impact on retail investors does not seem to be an illegal activity. It may be termed ‘predatory’ or even a ‘manipulative strategy,’ but not illegal. 

Also, we must appreciate that predatory practices happen across industries and are dependent on the concentrated availability of large amounts of capital. India has accepted this in telecom, oil and gas, e-commerce and various other sectors on the principle of may-the-best-player win.

The core issue today is our need for a regulatory framework that recognizes the complexity of monitoring sophisticated algorithmic trading strategies in the world’s largest derivatives market by contract volume. Sebi is a regulator par excellence, though it has had its moments of controversy. It just needs to upgrade itself to deal with a class of traders with roles that increasingly include market making, proprietary trading and quantitative analysis-driven trading in the algorithmic HFT space.

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It would be instructive to highlight how regulators globally approach patterns of abuse, especially around expiration, by HFT firms. Recent cases include Tower Research and DRW Trading Group in the US, Panther in the UK and Trillium in Canada. The approach of these markets’ regulators was similar. 

Whilst India’s detection philosophy is pattern-based with post-trade audits, the US Securities and Exchange Commission (SEC) uses tech-led real-time surveillance and trade reconstruction at the broker level. The SEC’s Consolidated Audit Trail and Midas mechanisms work by embedding regulatory devices within the system itself. 

In India, our focus must move from minimizing retail impact to ensuring market integrity and fairness for all participants. 

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First, given the advent of highly sophisticated algo-based trading strategies in India, Sebi should evolve an engagement-cum-enforcement model like the Commodity Futures Trading Commission (CFTC) in the US, which operates independently of the SEC. 

However, it would need reforms that encompass institutional, technological and legal domains. This should start with clear definitions of manipulation that, inter alia, include definitions of spoofing, layering, quote stuffing and other techniques used by HFT firms. As of today, Sebi uses broad terms like “unfair trade practices.” 

As with the CFTC, we also need differentiated oversight of derivatives with special emphasis on high-frequency trades. Apart from clear delineations of such white-collar crimes, collaboration with the Enforcement Directorate and Central Bureau of Investigation is a must to enable criminal prosecution that goes beyond the limited civil enforcement of today. 

Second, we need real-time surveillance infrastructure that can conduct consolidated audit trails, detect anomalies and closely monitor quote-to-trade data to spot any ghost liquidity, etc, at the broker level. Third, we must institutionalize algo/HFT operations; prior approval of algos via compulsory registration and risk-control mechanisms like mandatory automated risk limits will help. Fourth, international collaboration among regulators and transparency in enforcement orders will go a long way to strengthen our markets and assure all participants a level playing field.

Also Read: GN Bajpai: Sebi should review market infrastructure institutions

Manipulation, fraud, abusive trade practices and market domination are pressing issues with the entry of mathematically-based sophisticated entities that have large sums to deploy while we still lack counter-trading firms. If the right lessons are learnt from the Jane Street episode, we can improve our market integrity and transparency, raising India’s stature in the interconnected world of financial markets.

The author is a Sloan Fellow of the London Business School and advisor to chairpersons of corporate boards.