The Economic Times carried a story recently that told of how Direct Market Access would be allowed soon on the Indian markets. Automated trading algorithms would now scan the need to locate arbitrages of a different kind. Traditionally, we have understood arbitrage to mean the simultaneous buying and selling of the same security between different markets, when that was possible. Now with volumes being overwhelmingly concentrated on the NSE, that window is closed.
Declaimer: This article written was originally in August 2008, and some of the data points may be outdated.
Then started the ‘arbitrage’ between the major indices and the values of their underlying shares. In volatile markets, this kind of opportunity presents itself often. Another such ‘arbitrage’ is the difference in prices of a Future between the far month and the near month, between spot and Futures, and between Futures (calculated as synthetic put + call options) and Option prices. There is a surrogate for the ‘lending rate’ on the security markets and can be ‘stripped out’ and traded separately, like an interest rate. This interest rate should logically follow the patterns of the debt markets, but they don’t; usually because this ‘lending rate’ is decided by the balance between short-sellers and long-buyers in the market, and can sometimes have no relation to the debt market. In some specific stocks, the variances can be very large. A watchful ‘arbitrageur’ can locate these patterns and trade these strips like an interest rate, borrowing in the debt market, and ‘lending’ into the securities market.
explain of arbitrage
Complex arbitrages will start as the market becomes more efficient. I mention some of the above examples just to give the lay reader a sense of the broader meaning of the term ‘arbitrage’. Arbitrage is not a free lunch as commonly understood by most people. An arbitrageur provides a service to a market very similar to what a Logistics player provides to a commodity market, i.e. he buys where the price is low and sells where the price is high, thereby making the market more ‘efficient’.
For example, in the potato market, a trader/ arbitrageur often doubles up as a Logistics provider, buying the potatoes at the farm gate at a fixed price, taking the produce to market, and then selling it. He may be buying the produce at, say, Rs.5 per kg and selling it at Rs.10 per kg, but the entire difference is not profit. He incurs costs in financing and transporting the produce and needs to be remunerated for the price risk that he takes. His profit margins may be severely dented, if not fully eroded during periods of excellent price volatility, when he buys the produce at Rs.5 per kg but turns around to sell it, only to find that selling prices at the mandi have dropped to Rs.5 now. The total risk he takes is the sum of price (volatility) and the tenure (time) risk.
Sometimes, this agricultural trader is everybody’s whipping boy, especially during periods of food shortage. All traders are vilified by the media and the general public, especially politicians, when they send out the unpalatable price signals of the market. The vocal majority (by the number of people) makes a huge ruckus when this happens, like the recent case of high oil prices being blamed on ‘speculators’ or in earlier cases of high onion and sugar prices. Be that as it may, I only ask you to appreciate the fact that he performs a real and permanent role in the economy; we could argue about how much he should earn from this. Both the farmer and the potato consumer would miss him if he died; in fact, they would be put to great inconvenience if they had to replace him. Certainly, they would perform his role at a much higher cost in terms of money, time, and energy. Total prices of potatoes would go up if, for some reason, he was driven out of the market. The ‘spread’ of buying and selling potatoes would go up.
Now, the equivalent of this function is provided by a community of arbitrageurs on the stock markets. These people don’t have a separate identity, mostly lost in the community of ‘day traders’, that plankton of the markets on whom everyone feeds. Often called ‘retail participation’ by the media, this community is similar to the wannabes that you find outside any film studio, studiously combing their hair in the fond hope that some passing producer will notice them and that one day (they hope) they too will be film stars. Well, you and I know that hope is not a strategy, and the random outlier who does make it only proves the rule that randomness exists and it usually works against the crowd. But I digress…
Nobody has ever accused the poor day trader (or arbitrageur) of profiteering or making too much money. By the definition of a perfectly competitive market, this is impossible. Why then would anyone want to replace him with a computer program that transfers his role to an FII?
There are many layers to this argument, but I will deal with just a few of them
There are many layers to this argument, but I will deal with just a few of them. The first is equity and justice. Again and again, I find that this amorphous mass of people remains the silent majority, unaware of the implications of regulatory action and hence ‘voiceless’. They did not raise a voice when STT was imposed by a senseless Govt that saw nothing unjust in taxing a person who was not even making money in the capital markets. So while the actual Capital Gains in markets are taxed at a preferential rate, STT is paid mostly by the day trader, whose total turnover as a proportion of investible funds is the highest among the various segments of the market.
Now, they will not understand how these ‘arbitrageurs’ will be taken over by the FIIs, decimating a community that the regulator pretends to protect. As they slowly die, bid-ask spreads on stocks will increase quietly and nobody will understand the relationship between the two. Again and again, I find that regulations favor the ‘consolidation’ of players rather than fragmentation, which is the very purpose of a market. Profits from ‘arbitraging’ are shifting to an FII, which is not only iniquitous but also pernicious. How do we know that automated trading programs will not be linked to movements in markets elsewhere? That used to be seen as an unmitigated blessing, in the name of ‘integration or globalization’….till the sub-prime debacle taught us that integration was not such a great thing after all,.
Regulators need to have a broader philosophy of governance. The purpose of market regulation is to fragment them (markets), not consolidate them in favor of the big suits. This is not a leftist argument against computerization and the ‘efficiency’ brought about by it. Markets are volatile, jobbers and arbitrageurs will trade against the crowd and make money, what is wrong with that? If making money by trading against price imperfections is bad, then why not take this argument to its logical conclusion and have a ‘mandated’ price for Infosys?
The case I am making is that computer as an aid to trading is fair, but computers that are allowed to trawl the market for ‘arbitrages’ is not fair on the small guy. Further, these practices bring problems of their own, as we saw in the Black Monday and LTCM crises; automated trading is neither ‘efficient’ nor safe. Markets derive their ‘safety’ from not allowing any person, institution, or even thought process to dominate them. As markets zig and zag, discovering the truth and assimilating news flow, the person who best anticipates the market’s direction is anyway successful. Let that be the only way to gain success in the markets….
Progress needs to be defined properly. Blindly aping Western practices without an underlying philosophy in place will mean that such pernicious practices will be allowed unchallenged. Regulators need to judge themselves with a set of filters that clearly articulate their broader objectives. In this case, that would be the promotion of price discovery by HUMANS (with all their emotional failings) rather than computer models….
