On March 26, 2021, National Stock Exchange (NSE) released a circular stating that SEBI along with the major exchanges has come up with an additional order-based surveillance to deter persistent noise creators, along with the existing order-level surveillance mechanism. While this is a refreshing change for traders and brokers who have been in this industry for a long time, it's a confusing circular for the vast majority of people. Let's try to understand what this circular means, and how it will affect institutional and retail traders.
Who are the 'noise creators'?
By 'noise creators', NSE refers to those players who excessively modify or cancel orders with the intent to avoid execution of their trades, but manipulate the prices nonetheless. There are two methods by which markets can be manipulated like this
a) Spoofing and Layering
This is done by placing a large number of buy or sell orders either at one price or at multiple prices to create an illusion of demand or supply. While these orders do not get executed themselves, this illusion may cause other traders to take trades at incorrect prices.
b) Quote stuffing
Quote stuffing is also a form of market manipulation that is employed by high-frequency traders (HFTs) that involves quickly entering and withdrawing a large number of orders in an attempt to flood the market. This can create confusion in the market and trading opportunities for HFTs. Quote stuffing is also widely accepted to be the reason for the 2010 flash clash in the United States.
What will happen to the noise creators?
The NSE circular states that this surveillance measure shall be effective from 5th April 2021 and the first surveillance actions on these persistent noise creators will take place from 5th May 2021. The punishments that these noise creators (mostly proprietary desks and HFTs) will likely face include :
a)Trading disablement of that account for the first 15 minutes of trading at PAN level across the Exchanges in the Equity and Equity Derivatives segments simultaneously provided the number of instances exceed 99 on a rolling 20 trading days basis(i.e. previous 20 days prior to the specified day).
b)Additional instances of repetitive violation on consecutive trading days (say N times) on a rolling 20 trading days basis will lead to trading disablement for a period of ‘N’ instances X 15 mins, subject to a maximum disablement of 2 Hours (i.e. N < = 8)
So, does it affect retail traders?
The order-to-trade ratio defines the number of orders a trader makes for every executed trade. Last year, a circular was put out which said that traders having an order-to-trade ratio of over 50 (i.e. one order executed for 50 orders placed) were penalized. Again, these include scalpers and high-frequency traders. Most retail traders have an order-to-trade ratio of around 1 only i.e. one order executed for every order placed. Moreover, Zerodha's founder and CEO Nithin Kamath remarked that Zerodha never had a customer with an order-to-trade ratio of 50.
Therefore, retail traders are going to be impacted positively as prices will be less manipulated but HFTs could be in trouble if they intend to spoof or quote stuff on the market.
The big question mark in trader's minds is the potential lack of liquidity in the markets once this circular has been acted upon, especially after the new margin rules. Illiquid markets make trading very difficult as it will be difficult to get in and out of trades easily. However, this is just speculation and until this mechanism is implemented, we cannot assume the liquidity will fall in the markets. The expected change will be that the noise creating HFTs will slowly fade away and the honest ones will replace them.