- Shreya Belokar and Saud Javed
SYSTEMIC BARRIERS IN CAPITAL MARKETS: A RETAIL INVESTOR’S PERSPECTIVE
Over the years, the Indian securities market has witnessed landmark changes aimed at expanding the boundaries and increasing the efficiency of trade. One such change was shifting from a manual trading system to a full-fledged online screen-based trading system. This had to be done to tackle the voluminous trading, reduce the associated paperwork, and most importantly, inject greater transparency, thereby enabling access to accurate and timely statistics about the market activity to the advantage of participants. However, the growing incidents of freak trades and the failure of the stock exchange to record and disseminate information of transactions occurring in less than a second raises concerns regarding the present infrastructure and risk management system adopted by them. Such failure results in losses to the participants, deprives them of their right to have equal opportunity and an equal level of playing field.
Retail individual investor forming 45% of the market share in 2021, are the most affected due to the lack of proper infrastructure required to disseminate the data necessary to make appropriate decisions. Owing to the online system, an investor could enter the price and quantity of the securities to be transacted, and it is finally executed when a matching buy or sell order from the counterparty is found. The technological enhancement enabled the exchanges to maintain up-to-date records of the voluminous trading activities and offer instantaneous information to all the participants, making the process more efficient and transparent. It also enabled people to have equal access to the market with appropriate communication networks and reduced settlement timelines, regardless of their geographical locations.
Conversely, this system has been challenged by various systemic barriers emerging due to multiple factors such as unfavorable policy decisions, lack of updated infrastructure, and alike. These barriers have made the market more volatile and vulnerable to losses. These changes have created apprehension in the minds of retail investors to participate. Therefore, it becomes pertinent to address the existing barriers in the market to have a clear picture for developing and implementing effective policies and actions.
Recently, the stock market was observed to be impacted by a streak of freak trades. Freak trades are manual mistakes or systemic errors concerning security. Freak trades can have a severe impact on the price formation of a security and its related derivatives. They may also automatically trigger the execution of contingent orders such as stop-loss market orders or stop-loss limit orders.
One of the recent major incidents of a freak trade occurred on 20 August 2021, where traders saw abnormal spikes in several option contracts. There were “call options” that suddenly traded at a price of Rs 800 from an earlier Rs. 100. Moreover, the volume was significant, i.e., over six lakh quantities in less than a minute. Relying on the information displayed on charts by National Stock Exchange (“NSE”), the traders and numerous retail investors kept their stop losses far below Rs. 800 as that was a rational thing to do. However, the freak trade resulted in the triggering of stop-loss orders, leaving the traders perplexed as the graphs failed to show any changes. This, in turn, was due to the transaction not getting recorded on the charts as the spike duration was less than a second. This triggering of stop-loss orders due to the freak trade created a “domino effect.”
In simple terms, a retailer buys 10 equity shares for Rs 10 each and hopes that the prices of the security would go up. Based on the individual analysis, the retailer places the stop-loss order at Rs 8. If the price falls and stop-loss orders get triggered, the securities will be sold at a loss. If the market is going down and the stop-loss orders get triggered, the retailers would start exiting the market. This ultimately increases selling pressure and the prices keep falling due to the stop-losses placed, hence, creating a “domino effect.” Although the incident of freak trade happened within a moment, it caused severe loss to thousands of retail investors. Moreover, the online screen-based trading system was established to provide instantaneous status of the market and increase efficiency. Both these objectives seem to be unfulfilled and hit by such freak trades.
To prevent huge losses from such freak trades, retailers are suggested to use Stop-Loss Limit (“SLL”) orders, instead of Stop-Loss Market (“SLM”) orders, reduce the position size traded and avoid trading in instruments with less liquidity. However, these suggestions are temporary and shift the liability of exchanges and regulators on the participants by asking them to be more careful. Previously, to prevent freak trades, the Securities and Exchange Board of India (“SEBI”) issued guidelines for annulment of trades by stock exchanges, where the exchanges were empowered to annul trades either suo moto or on receipt of a request from stockbrokers for a maximum of sixty minutes. However, this step hurts retailers as they acquire positions across several assets such as equity and futures and cancellation of trades on one type of asset leaves them vulnerable to risk on the other asset. In addition, it also deters market trading strategies adopted to acquire stability during an erroneous trade. Thus, it fails to address the freak trades appropriately and leaves a great deal of ambiguity.
Removal of Trade Execution Range
On 16 August 2021, the National Stock Exchange (“NSE”) finally removed the Trade Execution Range (“TER”). The intention behind doing so was to eradicate the halt of a few minutes while the range is manually adjusted, in case the price of a contract reaches beyond the predetermined range. Consequently, now prices can go high and low. However, attention must be paid to the significant increase in the pattern of freak trades post the removal of TER. One of the main objectives of its removal was to allow supply and demand to decide the price but the streaks of freak trades would affect retailers' confidence, discourage participation and discourage them to enter the market.
TER, which was one of the major risk management systems is now inoperative. This certainly calls out for a more robust risk management system to create a more conducive environment for all participants. The SEBI circular on Internet Based Trading and Services prescribes certain requirements to be fulfilled and avail comprehensive risk management to ensure stability in case of unusual trading. However, here the onus of doing so seems more on the brokers than stock exchanges.
100% Marginal Requirement
The upfront marginal requirement is the amount paid to the broker at the time of purchasing/shorting a piece of security i.e., equity, future contracts, option contracts and alike where the broker can designate the appropriate amount for the respective security within the guidelines. For intraday trading activities, the calculated leverage or discounted price is provided by the broker. From March 2021, SEBI hiked the upfront margin requirement from 25% to 50%, then 75% in June, and ultimately raised it to 100%. Presently, zero leverage is being provided in the derivative segment making it onerous for the retailers to trade, resulting in weighing down participants’ involvement in the market.
A significant decline in volume has been seen because of these new rules, which is one of the major causes for extreme fluctuations and abnormal price behavior. Low volume in an instrument can create a major difference in selling price and current trading price thus creating a “spread.” The seller can ask for a higher price for trading security and due to low volume, the prices will jump to that higher price region. Consequently, the orders will be executed at a higher rate, triggering all the stop-loss orders in the spread. The retailer who is expecting a calculated loss according to its stop-loss orders placed gets baffled by a massive loss, as the orders will get executed at an unusually higher rate. Further, the peak margin rule of 100% margin requirement i.e., zero leverage or no discount, necessitates the trader to maintain an increasingly funded account. The logic behind this policy seems erroneous. Instead, the regulators must focus more on retail investors’ awareness and initiatives to prevent losses rather than eliminating the opportunity.
Dissemination of data and equal access to that data is pivotal in the capital market to make appropriate decisions. The screen-based online system was incorporated to achieve the above objective. However, the charts have failed to record and provide data regarding trades occurring in microseconds as noted in the incident on 20 August 2021. While there are enormous amounts of ticks or price changes happening in a second’s time frame, only a few are being streamed. The big institutional investors have knowledge and resources to obtain data and make more informed choices whereas, on the other hand, retailers are highly dependent on the data provided by stock exchange and brokers. SEBI in its discussion paper has highlighted the need of incorporating the new distributed ledger technology, blockchain, artificial intelligence, machine learning, and alike. Updating technological infrastructure is crucial to keep up with the new developments and challenges in the capital market. For instance, the London Stock Exchange has adopted blockchain technology to overhaul its trading processes and supervisory mechanisms. It would benefit investors by providing auto-execution of smart contracts, transparent real-time data, and secured real-time matching. Stock exchanges must consider the new developments that challenge the traditional functioning of the capital market and enable the exchanges to track and provide immediate and transparent information about the transaction.
In light of the above discussion, the aforementioned barriers related to inappropriate policy decisions, freak trades, and technological shortcomings have brought instability in the capital market. Unlike big institutional investors with adequate resources, retail investors face many severe repercussions of these instabilities. Moreover, there is an urgent need to introduce a middle path by adopting good governance practices which would work for the regulators as well as the public at large. Stock exchanges must bear the onus of adopting appropriate infrastructure and risk management, keeping up with the international standards, and updating it considering the technological advancements. In addition, the regulators must focus on investor education and awareness rather than erroneously forming policies to prevent losses due to error trades.