Online Trading Systems In India and Other Developed

Seventh Int.Conference on Opers. and Quant. Management August 3-5, 2006 Online Trading Systems in India & Other Developed Countries Sukhbir Kaur Regional Office , ICFAI National College- Jaipur sukh_@hotmail.com Priyanka Kawatra ICFAI National College-Kota priyankaemergence@yahoo.com Broad objective of this paper is to magnify the disparities between the existing online system in India and other developed countries, with special reference to US. The paper commences with elaboration of online trading aspects. Against this conceptual background it extends to aspects and issues regarding the online trading in India , as and when compared to system prevailing in other developed countries. In this regard, the legal (regulatory) aspects have also been discussed. In the conclusive part ‘ ushering reforms to perform’ , the authors of the paper have attempted to bring out certain suggestive assertions for system enhancement. Keywords : Online trading , information systems 1. Introduction Online Trading is an investment activity that takes place over the Internet without the physical inclusion of the broker. Alternatively, also referred as e-brokering here an end user (investor) has to register with an online trading portal ( like ICICIdirect.com) , thus enter into an agreement with this firm to trade in different securities according to the terms and conditions laid down on the agreement. Subsequently, the investors can place orders directly into the brokerage firm's online trading system, via the Internet, and circumvent the need for order entry by a broker. This head-on order placement by online investors has revolutionized the securities industry. Online Trading Systems in India & Other Developed Countries Page 1 4 August, 2006 Seventh Int.Conference on Opers. and Quant. Management August 3-5, 2006 1.1 Types of Brokerage Firms Offering broking services through the Internet is called E-broking. Brokers who offer trade services through the Internet are called E-brokers. There are two broad categories of firms which provide brokerage services1. Pure-play brokers who still instill towards offering offline broking – where customer is highly dependent on them. Not to escape , they make money on this equation. These brokers still treat online brokering with conservation as it takes away the client from their sphere of influence – skimps their services. 2. Offering broking services through the Internet is called E-broking . Brokers who offer trade services through the Internet are called e- Brokerage Firms /Online brokers - There are 2 types of online trading services: Discount brokers and Full service online broker. a. Discount online brokers allow to trade via Internet at reduced rates. Some provide quality research, while others simply don’t. b. Full service online brokerage account is linked to existing brokerages. These brokers allow their clients to place online orders with the option of talking/ chatting to brokers if advice is needed. Brokerage rates here are higher. 2. Online Trading Systems - Conceptual Perspective 2.1 Online Trading Systems - Defined A trading system (also called trading engine) comprises of a set of rules for market view and transactions. Technically, a trading system is a complicated computer program that follows the market to look for trends, analyze data, and then apply specific mathematical formulas to generate results. The trading system is associated with online trading platform, which enables actual trade order submission and order processing , using provided hardware, network connections, and various software linked to database while displaying price quotes. 2.2 Online Trading Systems - Evolution Trading systems have graduated immensely over the years. In this media has placed a pivotal functional role . Initially sustained by telecommunication technologies , it evolved into a system, where data communication has happen to evidence its criticality. The systems which have evolved over these years have been concisely outlined below1. 2. 3. 4. Hands-on Quotes , where prices are quoted over the phone-to-phone. Indicative Prices where prices are published but require manual confirmation Screen-based Trading , where prices can be executed on the screen Algorithmic Trading, where prices can be published and executed by computer itself. 2.3 Online Trading System - Functional/Operational Perspective Generally , speaking an online trading system refers to an electronic marketplace where clients can connect and post orders to buy and sell specified products. For this it deploys gateway to connect to the trading server or trading engine and send-receive messages- acknowledgements (ACKs) or negative acknowledgments (NACKs) . The trading engine which is at core of operations, functions to process newly received orders , process and place them in order book and execute matching function (secured) on the order. The process of online trading has been outlined belowOnline Trading Systems in India & Other Developed Countries Page 2 4 August, 2006 Seventh Int.Conference on Opers. and Quant. Management August 3-5, 2006 1. The client places an order. Once order-entry has been made , the Front-end system , returns a message to the client for order-confirmation. At the same time the member is provided with real-time quote for that security. Once confirmed , the order has to be routed to market for execution. Afore this the order traverses from the front-end to back-end. During this time , he order undergoes Vetting. During vetting, the system checks the user account for restrictions on member account, and verify whether or not the member has adequate capital , and also verify if the member is authorized to trade on margin. This is performed automatically , without human intervention, according to pre-programmed instructions. Vetting can be done either by the firm’s own system or sometimes a third part is contracted for the same. This party acts as firm’s clearing agent. One example of a prominent back-office provider is Automated Data Processing ("ADP"). If order does not passes, vetting, it is called an EXCEPTION. An exception , is manually reviewed by the broker at the brokerage firm. Once adequately addressed , the order is forwarded to market for execution. Once order has been approved manually , or electronically, it is routed to market or exchange or ECN depending upon the security listing for execution. Once an order has been executed, market maker, exchange or ECN forwards an Execution Report to the online brokerage firm, through the firm's back office provider or clearing agent. The agent or provider then forwards the Execution Notification to the online brokerage firm's back-end system, which is used to update the user's account information and order status screens. In times of high market volume and/or volatility, execution reports may be delayed due to capacity limitations and/or system bottlenecks , which means that although an online investor's order may have already been executed, the online investor's account may not be updated to reflect the execution. Later when the investor's account information is updated, investor may log into Member Areas and review account status. Some firms, also facilitate check of new buying power of the account. Some firms are unable to update buying power until the next day. In such cases, brokerage firm's clearing agent also generates a paper confirmation, which is then sent to the user through regular mail. The investor then has three days from the date of execution, known as the "Settlement Date," within which to fund the transaction. When brokerage firms receive payments from market makers as and when orders are routed to them for execution; it is known as "payment for order flow." On the other hand there are brokerage firms which do not receive payments for orders routed to ECNs. In fact, when using an ECN, the opposite occurs: brokerage firms are charged relatively small fees. Currently, individual users are not provided with the opportunity to choose where and how their orders are routed, but the issue is under consideration within the industry and may become a reality in the near future. 2. 3. 4. 5. 2.4 Different Types Of Trading Systems – Technical Perspective 1. Advisory Software Systems – These trading systems use rules to advise the user when to make trades, based on rules which tell the software which set of indicators and prices to monitor and associated levels at which traded instruments are to be bought and sold. These software systems can be connected to either real time market data, delayed data or a static database on storage media that is updated periodically. In the scheme of things, this category represents rule based systems that have been just automated to reduce time, effort and trading errors. Automated Systems - These trading softwares are preprogrammed with trading rules enabling them to make trades with minimal user input. These systems comprise of software modules, designed by third party vendors to operate under existing platforms, based on algorithms that identify price trends and market turning points. Thus their accuracy is rather limited because of presumed market volatility. An algorithm is therefore needed , so as to recognize when market volatility falls outside set limits. Procedural Rule Based Trading Systems- Here rules themselves make the trading system. This category consists of the purest form of trading system knowledge, stripped of auxiliary software tools and infrastructure, and involves the lowest cost . 2. 3. Online Trading Systems in India & Other Developed Countries Page 3 4 August, 2006 Seventh Int.Conference on Opers. and Quant. Management August 3-5, 2006 2.5 Online Trading Systems - System Components 1. 2. Portal – It is the website of broker, and provides interface to its registered clients who wish to execute trades. Order Routing System – It is a system that routes the client’s order to the broker’s back office. It comprises of Administration Module, Risk Management System, and Surveillance System. This system facilitates the broker to accept or reject orders and to forward the same to the exchange. Computer To Computer Link ( CTCL ) – This link aids in routing the order from the broker’s back office to the exchange Hardware and Network Components – These are the components required for setting up the entire system. 3. 4. 2.6 Online Trading System - A Three Tier Architecture System The three tier architecture system consist of the following: a front-end system, middleware and back-end system. 1. Front–End System (First Tier of Architecture) - The front-end system enables online investors to place orders directly into the firm's trading system. Generally, the front-end comprises of computer servers or web servers, which are controlled by application software designed to manage individual client sessions. The client accesses Internet (via ISP) , and enters online brokerage firm’s web-address , and enters firm’s system via firm’s webserver. For value-added features like free-research, delayed quotes, etc. no login is otherwise required. For other information, user has to login into firm’s secure investor account and trading areas (or member areas) , and here https:// protocol is exclusively used. For logging member areas, investor ha to enter UserId and password. This information is matched/authenticated against the brokerage firm's member database, only after which the online investor is admitted into the member area and may request for account information and place trades. Middleware ( Second Tier of Architecture)- It enables messaging, routing, and access to the firm's trading system. Middleware determines type of request that the user is placing, such as a request for research, quotes, or customer support, and routes the same to the appropriate part of the system for a response. For example, if it is requests for a quote, the middleware sends a message to the quote server for retrieval. The quote server forwards the appropriate response through front-end system, through web servers , and eventually back to the user, via the Internet. Back-end System (Third Tier of Architecture)- In this tier, Trading functions occurs. It is in the third tier where firm maintains its customer trading information, on either in database servers or a mainframe, and its "trading functionality," again on either servers, or a mainframe. 2. 3. Illustration :3-tier Architecture of Online Trading Systems Online Trading Systems in India & Other Developed Countries Page 4 4 August, 2006 Seventh Int.Conference on Opers. and Quant. Management August 3-5, 2006 3. Online Trading System – Comparative Perceptive (India and Other Developing Countries) Onset of online trading in India , has transformed value proposition of trading, allowing online brokers to supply investor with timely information. In developed countries, almost all exchange transactions are conducted online. The trend has slowly picked up in India and two of the largest exchanges, National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) have been conducting online trade successfully for sometime now. NSE introduced NEAT (NSE’s Online Trading System) in May 1997. BSE has deployed an OnLine Trading system (BOLT) on a Tandem platform which has a two-tier architecture on March 14, 1995. It claims to be able to support up to 2 million trades a day. It works on Tandem S74016 platform running on 16 CPUs. The Tandem Himalaya S74016 machines act as the backend to more than 8000 Trader Workstations networked on Ethernet, VSAT and Managed Leased Data Network (MLDN). BOLT is order driven and facilitates efficient processing , automatic order matching and faster execution of the orders and is very transparent. BOLT has a two-tier architecture. The trader workstations are connected directly to the backend server which acts as a communication server and a Central Trading Engine (CTE). Other services like information dissemination, index computation, and position monitoring are also provided by the system. A transaction monitoring facility in the Tandem architecture helps keep data integrity through non-stop SQL. This migration of trading services to cyberspace holds great potential for both - investors, as well as securities industry as a whole. But explosive growth of this industry also poses unique risks on part of investors and also tough challenges to regulators charged with ensuring the integrity of the trading environment. But Indian exchanges and brokering houses have rather been dawdling in their move to online transactions. This delay is owing to inherit Government regulations. Initially there was delay in laying down specifications for creating Closed User Groups (CUGs). Around 1998, this issue was resolved between the DoT and the Finance Ministry. It was soon followed by emergence of eagerly awaiting trade portals like ICICIDirect.com, motilaloswal.com, and smartjones.com. Appreciatively, along with the resolution of regulatory issues, India no longer has any pressing connectivity and bandwidth issues. With, the entry of private players into the broadband scenario and the government opening up the telecom sector, these issues are almost non-existent. Security solutions and services available in the market have matured and it doesn't cost a pretty packet anymore to put a simple backup solution in place. Starting at about 2 pct, online trading forms about 15 pct in terms of volume. Various segments have emerged to show interest in online trading due to its ease. These include housewives, retired professionals and even small businessmen. Online trading, has opened avenues for investors from all parts of the country with an internet connection. Online trading is gaining impetus in India with trading volumes growing by 150 per cent per annum. Over the past two years, the value of all trades executed through the Internet on the National Stock Exchange has grown from less than Rs 100 crore in June 2003 to over Rs 700 crore in July 2005 . There has been a massive rise in the number of Internet traders. At the end of July 2005, there were 108 registered brokers on the NSE, and about 1.054 million Internet trading subscribers. The top three players, ICICIdirect.com, Indiabulls and Kotak Securities, command nearly 85 per cent of the total customer base. ICICIdirect.com, the largest trading portal, has over 675,000 customers, followed by Indiabulls, Sharekhan and Kotakstreet. Compared to the Western countries, online trading is still in its infancy in India. With trading turnover at around Rs. 10 crores per day from online trading compared to a combined gross turnover of around Rs. 9000-10,000 crores handled by the BSE and NSE together, online trading has a long way to go. With some ten dotcom players, such as icicidirect.com, investsmart, 5paisa.com, indiabulls, and a host of brokers, such as kotakstreet, sharekhan, motilaloswal, Geojit Securities and duttstock, entering the online ring promises exciting times ahead. 5Paisa.com, ICICIDirect.com, IndiaBulls.com, Sharekhan.com, Geojit securities.com, HDFCsec.com, Tatatdw.com, Kotakstreet.com are some of the online broking sites in India. Online Trading Systems in India & Other Developed Countries Page 5 4 August, 2006 Seventh Int.Conference on Opers. and Quant. Management August 3-5, 2006 Banks woo customers to logon and mutually save time and money. In US, banks encourage customers to transact online by crediting around Rs 1,250 to them. Paying money to transact online is a far thought in India. Also, some banking Web sites can be difficult to navigate at first. Besides, a lot of fine print needs to be checked. However, for many people, the biggest hurdle to online banking is learning to trust it. Did my transaction go through? Did I push the transfer button once or twice? While the government, banks and financial institutions can do their bit in educating the public, on our part, we need to take a first step-that is, get an Internet banking facility. Another deterrent factors in online trading is technical infrastructure. It includes connectivity, security, backup, and recovery procedural costs. Currently, only icicidirect.com, and only few other players offers a seamless 3-in-1 package of broking, banking and demat accounts. However, the existing online trading system suffers from a major lacunae. Icicidirect.com currently offers online trading services only to those investors who have a bank or a demat account with ICICI. Or, investors can open an online trading account with kotakstreet.com only if they open a demat account with Kotak Securities and have a bank account either with Citibank, HDFC Bank or Global Trust Bank. If investors do not have these accounts, they have to go through the entire rigmarole of opening up the bank and demat account again for easy operation. Extra and latent charges built into the overall cost of online trading are amongst other discouraging factors. Given the poor connectivity and Internet infrastructure - Most e-broking majors are trying to raise the comfort level of the investors by assuring them that even if the Internet order-routing system breaks down, or investor access is broken for any reason, online registered investors can always exercise the option of putting through their orders offline. As this combination is still a new concept, most investors will be better off clarifying how the offline environment will operate, if the online environment fails for any reason. For the investor, the important thing is to ensure that this switch from online to offline is seamless and that there are no associated hidden costs. Clearly, from an investor's viewpoint, ``click-and-mortar'' approach to investing may be the best bet till the online trading market matures in terms of technology, infrastructure and service to become a self-sustaining business proposition. At this point in time, for most e-broking majors, the brick-and-mortar brokerage outfit is likely to subsidise the investment in online trading technologies and further in the ongoing/recurring costs. Unless the online trading volumes increase dramatically to 10-15 per cent of the total trading volumes (or at least 20 per cent of the gross turnover of the BSE and the NSE), the brick-and-mortar outfits will continue to dominate. 4. Ushering Reforms to Perform Over the years, Indian fincial markets have evolved continously, with assorted oectives of transparency, reduced tranasction costs, and better payment and settlement systems. Some of the steps like demutaulization, online trading and settlement systems have been a part of this evolutionary saga. But there is a long way to go. Government of India adopted program of liberalization , privatization, globalization and structural changes in the Indian economy 1991 onwards. In order to usher reforms to enable them perform, it is imperative to improve effectiveness of payments gateways, online trading infrastructure and reduce associated transaction costs, including cost of internet access. Circular trading can be curbed by making stock trade in trade-to-trade basis, where one has to pay for taking delivery and make delivery for selling the shares. This helps each transaction to register separately and timely weeding the much risk of Circular trading. Online brokers provide investors with only a faster mechanism for placing orders , vulnerable to occasional failures and slowdowns. This "expectation gap" is in part being fueled by aggressive advertising campaigns being waged by online brokerage firms. Many of the advertisements for online brokers -- a common sight on billboards, on television, and in numerous publications -- convey a message of convenience, speed, easy wealth, and the risk of "being left behind" in the online era. Stock markets functions on principle of anonymity, liquidity, transparency and arbitrage. Online trading exposes investor to risks associated with system failure, in advent of which the client is simply unable to enter new order, execute existing orders, and modify/cancel previously placed orders. Margin trading in India came into effect from April 2001., after about three years of non-existence. With this trading in Indian markets came at par with international markets. It is open for only those market participants who hold SEBI’s UIN (Unique Identification Number). Excessive day trading increases price volatility and deceitful brokers mislead investors by placing fake orders. To counteract this , aggregate bid and ask order quantities during continuous trading hours should be mandated. Use of Online Trading Systems in India & Other Developed Countries Page 6 4 August, 2006 Seventh Int.Conference on Opers. and Quant. Management August 3-5, 2006 internet brings investor on platform where information dissemination is very rapid. It also involves spread of unconfirmed / fictitious information on cyberspace. To overcome this a cyber watch system must be established that monitors rumors/news on cyberspace. Online trading can flourish when factors like infrastructure, and market regulations are in place. 5. Appendix Table 1 - Stock Exchange – Trading Systems , Trading Hours Exchange NSE BSE NYSE Trading system NEAT BOLT Floor trading Auction Market Screen based quote system with Automated execution system – - SORES (Small Order Execution System , for automatic execution of small orders up to 1,000 shares) - SelectNet for negotiated transactions and electronic executions. Trading Hours 9:55-15:30 9:55-15:30 9:30-16:00 India US NASDAQ (National Assoc. for Sec. Dealers in Automated and Quotation Sys) 9:30-16:00 Table 2 – Trading System Regulation in India and US Regulation Status in US Status in India Market Timings Late Trading Hot Money Fair Practices- Disclosures to Investors Fair Practices-Distributor’s Commission Conflict of Interest- Independent Directors/Trustees Insider trading laws Anti-money-laundering measures Overseas Investments WIP Yes * WIP WIP Yes Yes Yes Yes Yes Not yet relevant Yes No** No No Yes Yes Inadequate Operaing guidelines awaited Note - * Regulations in Place , ** Regulations not in place , WIP- Work In Progress  Late Trading is buying or selling of securities after trading hours or after cut-off time .  Money laundering is practice of engaging in financial transactions in order to conceal the identity , source and/or the destination of money.  Circular trading is process through which certain groups of persons come together and accumulate the floating stock from the market, to let the bull run for certain stocks. It breeds money laundering , converting black money into white without paying taxes.(no tax levied on long-term capital gain and short term is charged at 10%)  Penny Stocks are stock involved in circular trading. The are characterized by quote below par value, less liquidity, large equity of promoters, lack of institutional investor interest, and promoter is involved in the deal.  Insider trading is a consequence of information asymmetry, wherein one party has information access advantage and therefore tends to put transaction in his favor. In USA, insider trading regulated by Securities Exchange Act-1934. It permits Commission to file suit against insider traders. The Securities Exchange Commission (SEC) is also empowered under Insider Trading Sanction Act- 1984 t seek imposition of civil penalties, which can thrice the profit made in insider trading in addition to criminal proceedings. SEBI still has be empowered in a similar way. Presently , as per laws on corporate jurisprudence, shareholders are risk takers, and government Online Trading Systems in India & Other Developed Countries Page 7 4 August, 2006 Seventh Int.Conference on Opers. and Quant. Management August 3-5, 2006  largely escapes the regulation responsibility. This is indeed needed to promote growth and health of investment culture and securities market. Most of the setbacks system suffers is mainly due to failure of authorities in discharging responsibilities. Hot Money is large quantity of money (foreign fund) that moves quickly in international currency exchange. This fund temporarily reaches financial center , where from it can be withdrawn. 6. Conclusion Conclusively, computerization and automation are not to be avoided. Technology has been a positive enabler for stock markets. It has also led to development in terms of reduced costs and fewer errors. But IT cannot be applied as a panacea for all problems. Regulation and knowledge dissemination are still important. The use of technology should be preceded by a detailed study and assessment of all other alternatives. The key to successful use to technology is the appreciation of its constraints. 7. References [1] Case studies in E-Business [financial services] , ICFAI Books, The ICFAI University [2] Indian Financial Markets – Introduction , ICFAI Books, The ICFAI University [3] ‘ Comprehensive Regulatory Framework’ Chartered Financial Analyst, July-2005, The ICFAI University Press. [4] Reference #6M-2004-05-12-09 ,Margin Trading – Namita Gupta, Research Associate , Academic Wing , The ICFAI University. [5] Financial Markets - Chartered Financial Analyst- Dec 2005 , ref- #01M-2005-12-02-01, A.M. Sisodiya and A. Tandulwadikar. [6] Circular Trading : A Myth or Reality? Portfolio Organizer , ref- #6M-2006-01-04-01, The ICFAI University Press. Online Trading Systems in India & Other Developed Countries Page 8 4 August, 2006