Tweaking co-location norms may hit institutional brokers

Written by Ashley Coutinho | Ashley Coutinho | Mumbai | Updated: May 22 2013, 05:34am hrs
The Securities and Exchange Board of Indias (Sebi) proposed move to make co-location facilities more fair and transparent ensuring that even those that do not avail of this facility get a fair chance to execute their trades speedily might significantly impact large prop and institutional brokers who currently use the facility. However, smaller prop traders might benefit as their orders will get a better chance of getting executed.

Among other things, Sebis recently released discussion paper proposes to implement an architecture comprising two separate queues for co-located and non-colocated orders such that orders are picked up from each queue alternatively. It is expected that such architecture will provide orders generated from a non-colocated space a fair chance of execution and address concerns related to being crowded-out by orders placed from co-location, said the Sebi paper.

Market watchers fear that this alternative queuing of orders might impact the speed of trades executed at the co-location servers. If the speed of execution drops, the participation from traders will decline as well. It is the arbitrage participation that gives the market its depth and any reduction in arbitrage activity is not good for the market, said Nithin Kamath, founder, Zerodha, a discount broker.

Changes in the existing system could also impact volumes. Today, a broker may be placing 100 orders through the co-location facility and getting 15 matches. Once this facility is tweaked, I may get just 7 or 10 matches. This will affect the volumes and brokers may have to do a rethink on the effectiveness of programme-based trading, said a senior broker from a large broking house, on condition of anonymity. He further added that co-location facilities are used by brokers globally, especially in countries such as the US. Any deviation from international norms will create a problem for overseas clients trading in India as they are already accustomed to using these facilities elsewhere. Co-location is a facility typically used for cash and future arbitrage as well as put-call parity. The idea is not to take directional calls but to use high-speed trades to take advantage of mispricing on exchanges. The co-location facility is now used by around 100-150 brokers, mostly on the prop and institutional side.

The paper comes in the wake of concerns raised by a section of the market that trades of co-located market participants who deploy high-frequency trading algorithms tend to crowd-out the orders of participants who are not colocated. Also, the co-location facility is believed to be beyond the reach of small participants on account of high fees charged by stock exchanges. NSE charges anywhere between R20 lakh and R30 lakh per annum for a co-location server depending on the order size.

Industry observers believe that recent flash crashes on some of the international bourses may have also prompted Sebi to come out with the current discussion paper. However, they believe that, in India, there are enough checks and balances in place to ensure no algo strategy goes haywire and sends the market in a tailspin. While one can write algos without the requisite approvals from the SEC in the US, algos written here need prior approvals from the Sebi,said Kamath of Zerodha.