Taxi Drivers and Jane Street’s Billions

-By Sankarson Banerjee, Ex-CTO, NSE and EX-CIO, RBL Bank

India has recently been all agog about New York hedge fund Jane Street, which SEBI has debarred for manipulating markets in India and making outsized gains in the process. As usual, accusations such as taxi drivers are losing their life savings, the regulator was too slow to react, and that markets in India lack the maturity to protect themselves from manipulation have been thrown around, while Jane Street claims loudly that they have done nothing wrong. 

This triggered for me a somewhat different train of thought. Now I’m no expert on market structure and algorithmic trading but having spent a fair amount of time on the technology edge of things it occurred to me that there may be techie solutions to some of these ills. Jane Street and other hedge funds have used tech to gain (sometimes unfair) advantages, so maybe tech can help with the policing of it as well. That's what I want to explore today.

Incidentally, Jane Street has its own star on the tech boulevard – it is the largest user of an obscure programming language called OCaml. 

Not quite Hatke

This kind of manipulation is not entirely new; shenanigans involving Futures and Options (F&O) trades have occurred before. One example that immediately comes to mind is the case of Indian-origin UK citizen Navinder Singh Sarao, who used techniques like spoofing to generate significant gains on the Chicago Mercantile Exchange (CME). His actions, combined with other events, contributed to the 2010 Flash Crash, which exposed Sarao’s techniques and led to his arrest and guilty plea. 

This event prompted a raft of technical reforms in US markets, the most relevant for today’s article being the Consolidated Audit Trail (CAT). This requires all broker-dealers to report in T+1 an audit trail of all trades across all asset classes with specific customer identification requirements. Of course, change takes time; CAT which started the journey in 2016 became fully operational only by the end 2022 (and, to be fair, its real-life effectiveness is not yet known).

In the Jane Street case, the firm allegedly used a combination of cash and derivatives markets using multiple entities to execute manipulative strategies, which if something like CAT existed, would probably have been much easier to catch. Indian exchanges do have surveillance mechanisms, but they are focused on single asset classes and post-trade audits rather than being consolidated. SEBI announced an Integrated Market Surveillance System (IMSS) all the way back in 2005, but there seem to be strong doubts about its actual implementation as per a 2013 RTI by Moneylife. IMSS is clearly a miss.

There have been no subsequent announcements on this, and it’s unlikely something from two decades ago (before the High Frequency Trading boom in India) is effective in today’s market structure. SEBIs report on Jane Street does not mention IMSS, and Indian brokers are not required to submit anything like CAT’s information trail to enable surveillance of complex, multi-entity manipulations across asset classes. 

We need our own desi CAT to catch mice. 

Time for the Doosra

Segway number two emerges from a response to the front-running issues described in Michael Lewis’s Flash Boys. This was the founding of IEX in New York by Brad Katsuyama as a new kind of stock exchange. IEX created an alternative trading venue designed to minimise the advantages of high-frequency trading (HFT) using a 350-microsecond speed bump which levelled the playing field somewhat between HFT and regular traders. Now 1/3000ths of a second doesn’t sound like much of a speed bump but is actually quite material in the ultra high speed world; NSE or BSE operates at something like 20 microsecond latencies. 

Unfortunately no such alternative exists in India for investors seeking to avoid competing with HFTs, potentially reducing their risk of loss. The regulator should encourage the major exchanges to create one; there are no significant technical hurdles.

Why am I recommending such an alternative? Today the situation is like this – taxi driver Rahul Yadav trying to make money in derivatives against the giants of Wall Street is the same as Rahul Yadav taking his Mumbai taxi to a Formula One racetrack against Lewis Hamilton’s Ferrari -- throw in a few speed breakers and suddenly he has a real chance. Non-HFT venues usually have lower liquidity but well-established alternatives such as human Designated Market Makers (DMM) can be used instead, as is the case with New York Stock Exchange (NYSE). While Jane Street did not explicitly depend on latency for its manipulations, human DMMs would probably have been far more suspicious of the strange expiry date behaviours that Jane Street’s strategies exhibited. DMMs are not policemen per se but the red flags that were whispered about would surely have gone up faster and louder.

Inspector Avinash Hazir Ho

Our common man Rahul Yadav types wonder why HFT algorithms are not inspected by exchanges for misbehaviour. Well, it turns out that they are -- every algo has to be certified by the exchange – but not in the way you think. The certification process for algos can’t see the algorithm itself; those are trade secrets guarded better than the formula for Coca Cola (usually with legitimate reason). It focuses on unintended bad behaviour -- runaway protection, proper back testing, kill switches and the like. Intentional badmashi is not checked for. 

Can we detect intentional manipulation strategies even in a secret algorithm? One approach stems from the observation that most trading strategies degrade as they grow larger; when they’re large enough they move the markets and any price band advantage disappears. Algos can thus be back tested -- if they’re effective when small and lose effectiveness as they grow bigger -- that’s expected and reasonable behaviour. However, if they make money only when they’re a huge portion of market liquidity and not at smaller scales, then moving the market is key to the strategy and should be disallowed. Of course Jane Street’s trades involve multiple entities and coordinated algorithms so this particular approach may not have trapped them but other misuse such as Sarao’s strategies will probably get caught.

Jane jaye par…

India is the world’s largest derivatives market, so Jane Street is unlikely to be the last predator. There will be regulatory fixes and legal steps taken but we also need to improve the tech underpinnings of the Indian exchanges. For this, we need more sophisticated guardrails, better surveillance and tech catering to more kinds of markets. Done well, markets are a way for the Rahul Yadavs to participate in the country’s progress. Let’s make sure that dream survives.