Citihub Conversations, Part Two

Welcome to the second in our series of Citihub Conversations, where we discuss a range of topics on the intersection of technology with the financial markets – particularly in the high frequency trading space – with associates from Citihub, the specialist IT consultancy focused on the financial services industry.

In this interview, Mike O’Hara talks to Paul Chew, Partner (Asia Pacific) and Bob Mudhar, Associate Partner at Citihub, about the growing opportunities for high frequency trading in the Indian markets.

High Frequency Trading Review: Paul, can you give us a quick overview of the Indian equities market, in terms of liquidity and fragmentation?

Paul Chew: Yes, the NSE (National Stock Exchange of India) has been the most liquid market to date, but there’s a lot of evidence that the BSE (Bombay Stock Exchange) is taking active steps to close the gap, for example it was the BSE who pushed the regulator to approve smart order routing (SOR) in August 2010, although firms do still have to apply to the regulator to obtain a license to actually use SOR.

HFTR: And that is for smart order routing between the two exchanges, NSE and BSE?

PC: Yes. Essentially, SOR supports price discovery, so firms can approach both exchanges to determine where the best prices are to trade. As of this month, there are perhaps eleven firms who have been granted approval by the regulator to use SOR, although I think there’s only a handful who are actually implementing it and using it, so the market isn’t really feeling the impact of SOR yet. But we do believe it’s going to drive up volumes on the BSE, which historically has seen less volume than the NSE.

Bob Mudhar: I agree, the market has a long way to mature yet. Fragmentation is very limited, so I think the smart order routing on offer is more a marketing draw for institutional firms who are already used to it in other parts of the world.

It’s probably worth pointing out that although the dual-listed stocks are the same instrument and the same currency, what they’re not is the same settlement location, so there’s no opportunity to cross-net. In India if you trade on each exchange, you have to settle and clear with that exchange, you don’t have the advantages of aggregated clearing. That’s one of the reasons why the smart order routing impact isn’t as great as people might make out in the marketing; it’s still relatively expensive to clear trades in India. You would probably feel it more as a retail consumer because the fees relative to the number of trades you’re doing is likely to be quite high. Institutions are going to try and off-set that a little bit. But there’s still a way to go.

HFTR: Given the active steps that the BSE are taking, do you think liquidity will move their way?

BM: No, not at the moment. I don’t think NSE are complacent, but they are confident in the amount of liquidity and the spreads that they have. Liquidity is still king. NSE have still got relatively high fees, but they’ve got liquidity, they’ve got the volume.  BSE originally reduced fees and put in a maker/taker scheme but they still haven’t managed to capture that liquidity. The spreads on BSE are wider than on NSE. So although the BSE may be more suitable for high frequency traders from a technology and clearing perspective, it doesn’t yet have the liquidity or the spread.

The analogy with Europe would be Turquoise versus Chi-X. It’s not exactly the same here because BSE was first, but if you look at Chi-X when it started, it had the first mover advantage, it had much better spreads, much higher liquidity. Then Turquoise came along and slashed their fees, they had all these innovative market making schemes, they listed more products and tried to innovate in their market microstructure. But the liquidity stubbornly stayed with Chi-X.

It sometimes feels like that for BSE and NSE, that there’s still not the seismic change, there’s still not that killer app or killer function that will make people switch.

HFTR: What about off-exchange liquidity, MTFs and dark pools?

PC: Well, the regulator doesn’t support the use of dark pools right now and I don’t see that changing in the near term.

HFTR: In terms of order flow into the two exchanges, how much of it is retail and how much is institutional?

PC: Well, retail is still a big driving force in India, and that’s reflected by both the order book depth and also the number and shape of fills that you get for an exchange order. The Indian market has what you’d term classic retail characteristics, i.e. very small fill sizes.

If you look at the Indian market versus the rest of Asia, typically, in terms of total volume of messages generated between the client and the exchange, the Indian markets generate more volume than all of the other Asian markets put together. That’s essentially message volume on the back of order flow.

With that in mind, designing a platform for high volume has been essential and that’s what we’ve been supporting our clients doing. Fundamentally, latency is one of the key barometers of system health so significant increases in measured latency are indicative of a stressed platform which can lead to outages impacting reputation and resulting in lost revenue. So we’ve been working with our clients to analyse how latency degrades with volume and  identifying where the constraints are in the platform and working to eliminate them rather than focusing just on low latency. So with clients in Europe and US we’ve spent time optimizing their platform whereas in Asia and specifically India the focus has been on stability, reliability and improving the measurement of latency.

HFTR: What about the market participants, are there any players who do a significant amount of volume?

BM: That’s difficult to know because it gets obscured. If you look at the tape for these exchanges, there are so many small executions that it’s really hard to piece it together.

It’s a little reminiscent of the Paris Exchange back in the early 2000’s, where they used to have a very, very deep order book, sometimes to obscure the fact that there might be a big institution out there.

But this whole point about the number of fills is particularly important for HFTs because it’s not enough to be fast and to lead at the order entry point of view, you have to be able to book all this stuff as well. And I think people underestimate how much flow you have to book in India.

For example, if you have a VWAP order in Europe, you might have a couple of hundred fills to book if it’s a VWAP across the day. But in India, you’re looking at possibly a couple of thousand fills, which presents a very different challenge. And there’s no point trading it if you can’t book it, settle it and clear it.

HFTR: Can you give us a bit of an idea of what the regulatory landscape is like, particularly for overseas firms who want to participate on the Indian markets?

PC: First of all, the exchanges do not allow remote membership. Firms need to operate under a local subsidiary in India, which is regulated by SEBI (Security and Exchange Board of India). And that’s for participation in any domestic ventures, such as custodial or asset management services, not just for trading. It’s also worth saying that both the BSE and the NSE are self–regulated. So, member firms need to conform to rules stipulated by the two exchanges.

HFTR: Are there other restrictions, for example around short selling?

BM: Short selling is prohibited, but that’s not uncommon on “immature” markets, where the idea is to prevent speculation. Will the authorities ever relax it? Probably, but not yet. It’s all tied in with the stock borrow and loan situation, and how easy it is to borrow stock if you’re short. One of the biggest worries for the financial regulator is that the infrastructure to build up a mature and active stock borrowing and lending environment is quite significant. If they allow short selling, that implies that they allow stock loan and borrowing and at that point, I suspect that they’re worried that the international firms will move and take that market over.

HFTR: Aren’t the international firms already moving in and co-locating, offering DMA (Direct Market Access) to overseas customers?

PC: Well, co-location is fairly new to India, and it’s something that BSE in particular are pushing right now, in order to attract more clients to the market.

However, connections require user IDs (which have costs associated with them) and the matching engine speeds are currently pretty low.

BM: I think that’s an accurate assessment. When they allowed DMA a couple of years back, there was a big uptick in volume, liquidity and volatility.

It’s a strange mix, they’ve got the short selling rule, but yet they allow DMA and co-lo. It’s a bit like India itself, a big conundrum!

HFTR: For those firms who offer DMA, are they obliged to run any standardized pre-trade risk checks?

BM: There’s no naked access but I think the emphasis is on the broker to provide the adequate risk checks. And if you look at some of the big global firms that are out there, they all will have global risk checking.

The futures markets in particular have really stringent pre-trade checking. Also, there’s still the concept of “One Touch” DMA where manual intervention is required by the sell-side before it hits the market. This is despite the fact that SEBI introduced “no touch” DMA in April 2008. There has been weak adoption of “no touch” DMA because client side implications mean not all clients are comfortable signing up and would rather stay with “One Touch”.

HFTR: Doesn’t that have a big impact on the latency and speed of access?

BM: It does. And obviously the two main things that high frequency traders are interested in are the speed and the cost of trading. Anything structural that gets in their way, like a touch, is going to be an issue. No doubt some trading firms have clever ways to get around it, which are proprietary to them and part of their USP.But once that restriction is removed, I think it will open up the door for HFT.

HFTR: Moving away from equities for a moment and looking at the commodities and derivatives venues, the Multi Commodity Exchange (MCX), the Universal Commodity Exchange (UCX) and the new United Stock Exchange (USE). How liquid are they and do you see any opportunities for HFT there?

BM: The Gold ETF is getting popular. As you know, I’m Asian and I can tell you that Asians do like their gold! So any way to invest in that commodity is probably going to be popular. And the interesting thing for me is that with all the other gold contracts in the world, a Gold ETF in India is probably going to be arbitragable at some point in time. So, it’s a smart move for NSE to enter that ETF space.

As for other commodities, in terms of oil, there’s not a huge amount in India really, so I’m not sure about liquidity there. Although interestingly, they are big into liquified petroleum gas (LPG). Like natural gas, a lot of their infrastructure rides on it. So, I think commodities are going to be interesting and ETFs probably even more so, because of the unbundling effect of the arbitrage that gives.

HFTR: In conclusion, what other arbitrage opportunities might there be for high frequency traders in India, aside from ETFs against commodity futures, and possibly NSE stocks versus BSE?

BM: One that’s interesting, which I think is under-exploited, is ordinary stocks versus ADRs traded overseas, for example on the LSE. Most of the bigger Indian companies are listed on the LSE as ADRs, or more specifically GDRs (Global Depositary Receipts). So that presents an opportunity because you can trade the ords in India and the GDRs in London. They have different order books, different price formation mechanisms, different opening and closing auctions, but generally you can freely convert GDRs to the ords for a small charge for each conversion.

So that’s an interesting one. As soon as you’ve got that and you’ve got some sort of index, there’s a three-way arb opportunity between the ords, the GDRs and the index futures contract. It’s a bit like what happens extensively between Moscow and London, where on MICEX you’ve got all your Russian ords in Roubles and in London, you’ve got all the ADRs in stocks like Lukoil. Then when the LSE launched derivatives on the ADR contracts, that opened up another dimension, and I can see that happening between London, India and whoever is listing a futures contract.

HFTR: Well, it will certainly be interesting to see how the market develops. Thanks Bob, thanks Paul.

Do you currently trade on the Indian markets? If so, what sort of challenges have you faced?

Or are you looking at potential trading opportunities on either the BSE, the NSE or one of the Indian commodities exchanges? If so, where do you see those opportunities?

Are there any particular questions you have regarding the Indian markets that we haven’t covered here?

We’d be very interested in hearing from readers who either have experience in this area or are looking to find out more, so please feel free to join the conversation by submitting your questions and comments below.