By Nidhi Aggarwal, Chirag Anand, Shefali Malhotra, Bhargavi Zaveri
Orders that match with each other with no resultant change in the ownership are termed as self-trades. Lately, there have been increased concerns regarding self-trades in equity markets in India. With no genuine trading intent, these trades are seen as manipulative in nature, aimed at artificially pumping up the turnover to portray a false picture of liquidity. Self-trades are prohibited under the present law, and SEBI has punished several firms on this score.
In this article, we argue that there are some kinds of self-trades which do not constitute market abuse. With no manipulative or fraudulent intent, a trading firm can hit its own bid or offer. Penalising firms in such situations is wrong, and can act as a deterrent to trading in capital markets. Internationally, regulators have realised such possibilities, and taken necessary steps to ensure that legitimate cases of self-trades do not get punished. The Indian regulator needs to undertake similar steps.
2 Legitimate self-trades
Self-trades are generally considered to be non bona fide transactions. However, there can be instances where genuine trading intentions within the same firm result in self-trades. Such trades can occur in the course of normal trading when i) orders from two independent trading strategies coincidentally interact with each other, or orders originated from the same trading desk match with each other due to technical and operational limits of the existing infrastructure (such as matching engine technology). The following text illustrates such situations in detail.
2.1 Manual trading
Proprietary trading firms typically have several dealers operating in multiple securities. These dealers, independently, deploy trading strategies to make profit and to manage their own risk. Orders from these independent dealer desks originate from accounts with common ownership. Such orders, though initiated with legitimate purposes, can result in self-trades.
As an example, suppose a firm has two independent dealers. Both these dealers could be separated from each other by information barriers. Suppose they pursue following strategies:
- Dealer 1: Arbitrage between BSE-NSE stock prices
Under this strategy, arbitrage opportunities arise when the price of a security trading on both BSE as well as NSE diverges significantly. By selling the security on the exchange with higher price, and buying on the one with lower price, a trader can make arbitrage gains.
- Dealer 2: Bullish strategy
In this strategy, the trader has a view about the direction of a security’s price based on his analysis. If he anticipates that the price of the security is likely to go up in the future, he will buy that security. The trader makes a profit if the price actually moves upward at a later time-period.
Suppose that at a certain point of time, Dealer 1 sees a significant divergence between NSE and BSE prices of a security, with higher price on NSE and lower price on BSE. He, thus, sends a buy order on BSE, and a sell order on NSE to pursue his arbitrage strategy. Dealer 2, at the same time, places a buy order on NSE in pursuit of his bullish strategy on the same security.
Though completely legitimate, and without an intent to manipulate, the two buy-sell orders on NSE from two independent dealers can end up matching with each other. This trade, while being unintentional and completely co-incidental, when tracked at the legal entity level of the parent proprietary firm, will be characterised as a self-trade.
2.2 Algorithmic trading
The incidence of self-trades increases much more in the case of automated trading due to higher speed and the use of algorithms for making trade decisions. Similar to manual trading, two different algorithms within the same firm could be trading completely unrelated strategies. However, orders originating from these algorithms can also interact with each other without any malicious intention.
2.3 Latency issues
Another source of legitimate self-trades could be technological limitations. Exchanges and trader terminals are situated at different physical locations which affect order placement and trade confirmation timings. Orders sent to two different exchanges could reach with a delay because of difference in the speed of computer network lines. This time delay is known as “latency”.
Algorithmic trading strategies doing arbitrage across two exchanges continuously send buy and sell orders. Due to latency differences across the two exchanges, traders may get “trade confirmations” exchanges at different time-points. A possible scenario where a self-trade can happen due to such technological issues and with absolutely no malicious intent is described below:
- The arbitrage algorithm keeps sending buy orders to BSE and sell orders to NSE based on a price difference.
- For a particular set of orders, trade confirmation on one leg of the order is received from one exchange, but not from the second exchange.
- Meanwhile, the trader’s algorithm sends a second pair of a buy and sell order to BSE and NSE respectively.
- Later, it is realised that the second leg of the first order on BSE did not get execution. The trader will, thus, have to reverse the executed position on NSE for the first order.
- To reverse the position, the trader sends a buy order to NSE.
- This buy order on NSE ends up interacting with the sell order sent in Step 3 resulting in a self-trade.
All of the above are cases of self-trades that can occur within the same firm, but from separate or distinct underlying strategies with genuine trading interest. These examples show that it is wrong to think that all self-trading is market abuse.
3 Regulatory mechanism worldwide
Self-trading in securities is a concern for regulators worldwide. It has, however, been recognised that such trades can also happen with legitimate purposes. As a result, regulators globally have made various changes to accommodate for such transactions.
3.1 The US securities law
In an amendment to the securities law, the US SEC approved a rule change proposed by the Financial Industry Regulatory Authority, Inc. (FINRA) relating to self-trades in 2014. In its description of the proposed rule change, FINRA noted:
- Transactions resulting from orders that originate from unrelated algorithms or from separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades.Thus, the proposed rule allowed for legitimate cases of self-trades arising from unrelated trading strategies. Caution is however taken in allowing this form of activity by the use of the word “generally”. In its response to a comment, FINRA noted:
“although self-trades between unrelated trading desks or algorithms are generally bona fide, frequent self-trades may raise concerns that they are intentional or undertaken with manipulative or fraudulent intent”.
- FINRA issued guidelines for members to have policies and procedures in place that are reasonably designed to review their trading activity for, and prevent, a pattern or practice of self-trades resulting from orders originating from a single algorithm or trading desk, or from related algorithms or trading desks.FINRA noted that even if not purposeful, a material percentage or regularity of such transactions from related desks, may give a misimpression of active trading in the security. This can adversely affect the price discovery process. It is therefore recommended that members must put in place effective systems to prevent such trades. But it also stated:
“the rule will not apply to isolated self-trades resulting from orders originating from a single algorithm or trading desk, or from related algorithms or trading desks, provided the firm’s policies and procedures were reasonably designed”.
In defining “related”, FINRA stated its understanding that discrete units within a firm’s system of internal controls typically do not coordinate their trading strategies or objectives with other discrete units of internal controls, but that multiple algorithms or trading desks within a discrete unit are permitted to communicate or are under the supervision of the same personnel and thus, are presumed to be related. It also stated that the proposed rule permits firms to rebut this presumption, suggesting that a firm could demonstrate that “related” algorithms or trading desks are in fact independent or are subject to supervision or management by separate personnel.
Subsequently, after receiving comments from market participants on the proposed rule change, and minor amendments to the proposed law, the SEC approved the proposed rule change in May 2014.
The current rule reads as follows: Under the FINRA/SEC rule 5210(.02):
“Transactions in a security resulting from the unintentional interaction of orders originating from the same firm that involve no change in the beneficial ownership of the security, (“self-trades”) generally are bona fide transactions for purposes of Rule 5210; however, members must have policies and procedures in place that are reasonably designed to review their trading activity for, and prevent, a pattern or practice of self-trades resulting from orders originating from a single algorithm or trading desk, or related algorithms or trading desks. Transactions resulting from orders that originate from unrelated algorithms or separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades. Algorithms or trading strategies within the most discrete unit of an effective system of internal controls at a member firm are presumed to be related.
3.2 The UK securities law
The Financial Conduct Authority’s (FCA) guidance also allows self-trades for legitimate cases. As per FCA MAR.1.6.2(2):
“Wash trades: that is, a sale or purchase of a qualifying investment where there is no change in beneficial interest or market risk, or where the transfer of beneficial interest or market risk is only between parties acting in concert or collusion, other than for legitimate reasons”.
3.3 Self-trade prevention mechanisms by exchanges
With no information barriers and no technological limitations, it will be optimal that trading firms implement mechanisms to prevent self-trades at their own end. However, such an ideal world does not exist. In such a scenario, could we demand that trading firms establish systems to ensure that self-trading does not happen? Since matching occurs at the exchange’s order matching platform, and hence, some degree of self-trades could be difficult to detect at the trading firm’s level.
For example, when two separate dealers within the same firm send their orders to the exchange at different time points, those orders may still end up matching with each other if there are no other orders in the book. This can happen if one dealer sends a `buy’ limit order at some point, while the other sends a `sell’ market order at some later point of time. Similarly, if there is a large `aggressive’ buy order sent by one dealer, and a normal sell limit order by another dealer which sits in the book, the `aggressive’ buy order will first interact with the higher priority sell orders. If still some balance of this buy order is left, it may then end up matching with the second dealer of the same firm. In yet another case, it can also happen that one dealer sends a limit `buy’ order at a point of time, but due to limitations in the exchange’s order matching technology, it stands in the queue. After a point, another dealer from the same firm sends a ‘sell’ limit order and that order stands behind the first dealer’s order. These two opposite orders can also ultimately end up matching with each other.
With no malicious intent, in all the above cases, these self-trades are inadvertent and difficult to identify at a trading firm’s level. Several exchanges including the NYSE, CME, Euronext, Canadian Securities Exchange, ICE, NASDAQ have implemented self-trade prevention (STP) mechanisms that alert the traders to the occurrence of a self-trade from the same member, and let them make a choice to either, cancel the resting order, or the aggressive order. Some of the exchanges including the ICE and NASDAQ give the a choice to opt for the use for this service at either the company, group, or trader level.
In India, BSE introduced a similar system in January 2015 on its equity derivatives and currency derivatives segment. It extended the facility to the equity segment in March 2015. NSE will be introducing self-trade prevention mechanism in the currency derivatives segment starting August 3, 2015. The systems, on both the exchanges, however, only cancel the incoming (active) order of the client.
4 The current regulatory framework in India
Under the current regulatory framework, Regulation 4(2) of the Securities and Exchange Board (Prevention of Fraudulent and Unfair Trade Practices of Securities) Regulations, 2003 (SEBI (FUTP) Regulations) prohibits a person from indulging in a fraudulent or unfair trade practice.
The operative part of the regulation 4(2) reads as under:
“Dealing in securities shall be deemed to be a fraudulent or an unfair trade practice if it involves fraud and may include all or any of the following, namely:-
(b) dealing in a security not intended to effect transfer of beneficial ownership but intended to operate only as a device to inflate, depress or cause fluctuations in the price of such security for wrongful gain or avoidance of loss; …
(g) entering into a transaction …without intention of change of ownership of such security;…”
Since the buyer and seller in a self-trade are the same entity, there is no change in ownership of the shares. Clause (b) of Regulation 4(2) prohibits self-trades originated with manipulative intentions.
5 Issues with past SEBI orders on self-trades
We outline a case below and highlight how SEBI has failed to provide sufficient evidence of market manipulation, and refused to recognise co-incidental and unintentional self-trading activity which occurs (a) within a firm or (b) as a result of algorithmic trading.
(a) The Adjudicating Officer (AO) said:
“It may be noted that these different CTCL ids belong to the same Stock Broker / legal entity i.e., noticee, therefore, matching of trades amongst them will have to be considered as a ‘self-trade’.”
“Further, the argument of the noticee that final trader id may be identified by CTCL id is not the right interpretation and the self-trades at the member level has to be considered because the UCC for each client is different in case of trading for clients whereas in the case of proprietary trading the trades are executed in member’s ‘PRO’ code irrespective of number of dealers / traders employed to execute the proprietary trading.”
The AO, here, considered a proprietary firm’s trading activities solely from the viewpoint of the legal entity, and not at the trader id or dealer level.
As described above as legitimate cases, self-trades occurring from unrelated trading desks, and functioning independently may not be manipulative, and need to be considered separately. Exchanges themselves, register the user id and terminal ids for each dealer. It is therefore, inappropriate to not consider trades at the level of traders or terminals.
(b) The AO said:
“… the total self-traded volume is 78,927 shares at BSE and 38,229 shares at NSE which is very high.”
“The number of instances of self-trades executed by the Noticee is extremely high i.e. 6,051 trades at BSE and 2,985 trades at NSE which is not miniscule by any stretch of imagination as contended by noticee.”
The AO states that there was a very high scale of self-traded volume. The said volumes are respectively 0.53% and 0.10% of the total quantity traded that day on the security on BSE and NSE. SEBI failed to establish materiality by comparing these numbers to an appropriate benchmark.
6 Judicial treatment of unintentional self-trades
The Securities Appellate Tribunal (SAT) has, previously, refused to acknowledge unintentional self-trades that emanate from independent terminals and traders, and has obligated firms to prevent self-trading by all means.
- In Systematix Shares & Stocks (India) Limited vs SEBI, SAT held:
“..Trades, where beneficial ownership is not transferred, are admittedly manipulative in nature”.
- In Anita Dalal vs. SEBI, SAT held:
“Self-trades admittedly are illegal. This Tribunal has held in several cases that self-trades call for punitive action since they are illegal in nature.”
- In Triumph International Finance Ltd. vs. SEBI, the Tribunal held:
“The buyer and the seller were also the same. It is obvious that these trades were fictitious to which the appellant was a party. They were fictitious because the buyer and the seller were the same.”
In India, FUTP regulations do not deal with legit self-trading activity which may happen within a firm without intent of manipulation. Since there is no clear law which deals with self-trades specifically, even genuine self-trades activity often falls under the “unfair trade practice” category.
In light of these issues, the following changes are proposed as a solution to deal with self-trading activity.
7.1 Legislative actions
The current SEBI FUTP regulation 4(2), 2003 should be amended as:
- Clause (g) of 4(2) treats all self-trades as manipulative and should be removed.
- The following clauses should be included in this section:
- Transactions in a security resulting from the unintentional interaction of orders originating from the same firm that involve no change in the beneficial ownership of the security, generally are bona fide transactions. Transactions resulting from orders that originate from unrelated algorithms or separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades.
- Algorithms or trading strategies within the most discrete unit of an effective system of internal controls at a member firm are presumed to be related.
- Members must have policies and procedures in place that are reasonably designed to review their trading activity for, and prevent, a pattern or practice of self-trades resulting from orders originating from a single algorithm or trading desk, or related algorithms or trading desks.
7.2 Improvements in SEBI processes on the executive functions
The following measures should be adopted by the regulator to deal with, and investigate self-trading activity:
- Before starting the investigation, the number of shares traded via self-trades should be significant i.e. above an appropriate benchmark, in terms of volume and value of transactions.
- The regulator should be able to reasonably demonstrate the impact of self-trades on the price.
- Patterns and practice of self-trades should be looked at before considering them as manipulative.
- Exchanges should implement Self-Trade Prevention systems and offer these services to its members on a voluntary basis.
- The regulator should issue guidelines regarding self-trading in line with the proposed changes to the law.
These rules need to be woven into the internal process manuals at SEBI on enforcement against market abuse.
At present, subordinate legislation by SEBI, enforcement actions by SEBI and rulings at SAT are unanimous in viewing all self-trading as being synonymous with market abuse. In this article, we have demonstrated that this presumption is incorrect. Some but not all self-trading is market abuse. Financial regulators elsewhere in the world have obtained greater precision in enforcing against market abuse while not punishing legitimate actions. We have shown actions that need to be undertaken at SEBI on the legislative and the executive side in order to address this problem.
The discussion above has been couched in the language of the equity market, which is the most sophisticated component of the Indian financial system. It is, however, completely general and pertains to all organised financial trading. As an example, if SEBI implements the above improvements, all this progress will immediately accrue to commodity futures as SEBI is now the regulator for commodity futures trading also. In the future, when the Bond-Currency-Derivatives Nexus moves from RBI to SEBI, similar gains will accrue there also.