Jane Street: Is It Time To Reinvent Rules For The Derivatives Market?

The Jane Street saga has once again brought the intricacies and complications of options trading under the spotlight. The US-based firm was accused by the markets regulator, the Securities and Exchange Board of India (SEBI), of manipulative practices that allegedly led to unlawful profits in the country.

As of Monday morning, Jane Street deposited Rs 4,843.58 crore in an escrow account, requesting SEBI to remove the trading ban. Earlier, Jane Street had responded, saying that SEBI had misunderstood its trading strategy and also alleged its use of ‘inflammatory language’.

While the final order is pending on the issue, many traders believe that the regulator should have acted quickly to curb the practice. A few even say that the exchanges should have taken a more proactive approach.

“To prove a case takes time, as regulators need data and evidence. They cannot act based on a hunch,” said Ambareesh Baliga, market expert and independent market analyst, told The Core.

While Jane Street is the first of its kind, there have been other similar scandals before. “I can compare this with the co-location scam, where brokers used to take advantage of the colocation facility. They say that you got a price advantage because of the HFT (high-frequency trading) software you had, your HFT trades were executed much faster than other brokers who are similarly placed,” said Ravi Hegde, founding partner at RHP Partners and securities expert.

The NSE co-location scandal came to light in 2015 when it allowed trading members to place their servers within the exchange premises for faster access to markets, giving them an undue advantage.

While this scandal unfolded over a decade ago, some of these practices continue to this day, giving HFT traders heft in a market that seems to be ruled by them.

In light of the developments on Jane Street, there is a growing consensus that regulatory and exchange-level surveillance of trades must be strengthened through reporting requirements, imposing limits on how much can be traded on expiry and more such measures. Greater transparency could also help level the playing field for all participants in the derivatives segment.

Silent Manipulation

The world of F&O trading is ruled by large proprietary firms with retail investors sitting at the short end of the stick.

The modus operandi that HFT firms use to manipulate the trades is simple, ingenious and convoluted. Market veteran Arun Kejriwal, founder of Kejriwal Research Investment Services, said that HFT is where multiple orders are generated via a formula that’s fed into the system.

“Each time a price movement occurs, an order is generated or executed by the algorithm, without the intervention of a human who is not thinking. The size of the lot, shares and value are pre-decided by the firm,” explains Kejriwal.

Another characteristic of HFT is the time taken to execute the trade. “Multiple orders are executed within a nanosecond. High frequency trading also requires mathematical prowess,” informs Baliga.

To put things into perspective, there are one billion nanoseconds within a single second. To be able to execute such trades, these trading firms use a mix of high-speed computers that can process enormous amounts of data in real-time, using low-latency networks, co-location services that ensure time isn’t wasted, all designed to take advantage of short periods of opportunities that lie in the markets. On top of these are advanced software and complicated algorithms that are proprietary to such firms.

Retail traders who are at the other end of the spectrum do not have these tools, and only a select few understand the intricacies of the trade as much as trading firms do.

Is It That Easy To Manipulate Trades?

Apart from prowess and intent, the volume and the magnitude of the trades executed made it possible for such firms to ‘move the markets’. Markets regulator SEBI alleged that Jane Street made as much as Rs 36,500 crore, and banned the firm in India until a final order is issued on the matter.

Jane Street used a simple yet ingenious play. On the last day of the expiry of options, it executed trades which artificially inflated as well as deflated the price of options, in a way that indices were manipulated. One of its prime targets was the Bank Nifty index.

“Two important phenomena take place on the last day of the expiry. The weighted average price is derived from the last 30 minutes of the options' expiry. This weighted average price is used as settlement price for open positions at the close. One can derive a price that slides by using multiple trades to pull it up or down by trading in large volumes on the last day,” explained Kejriwal.

These concentrated positions lie on the other side of the grey line — they cause conflict of interest, push up volumes and influence the prices. “They are not the right principles of trade,” sums up Baliga.

While the manipulation itself was successful, many checks and balances do exist in the system to catch such practices. At any given point in time, the stock exchange was aware of the open positions taken by trading firms such as Jane Street.

“So, what SEBI says is that you were trading aggressively during the expiry days. There is no commercial sense in your trading pattern where you buy excessively and immediately in the second patch, you are squaring it off. Now, why do you do that? Because it has an underlying effect on the index,” said Hedge.

Apart from technology and algorithms, Jane Street’s ability to manipulate the markets also stems from the amount of money it poured into the trades. As pointed out by Zerodha founder Nitin Kamath, proprietary trading firms like Jane Street contribute nearly 50% of India's options trading volumes. While retail investors contribute to 35%, are retail traders set up to lose in a system shadow-managed by such hedge funds?

Retailers And The Game Of Trades

The markets regulator has for a long time been warning retail traders about the fallout of F&O trading. As per a SEBI analysis released last year, about 93% of retail traders incurred an average loss of Rs 2 lakh per trader between FY22 to FY24.

The aggregate losses of around 11.3 million retail investors amounted to Rs 1.8 trillion for the period mentioned above. It indicates that a lot of retail money across millions of investors is chasing the technically complex, technologically complicated world of F&O trading.

Among those who make profits, only 1% of them made above Rs 1 lakh — indicating that retail investors gain less and lose more. Despite the losses, a lot of them continue to trade in F&O showing that the lure of quick money exceeds the fear of loss.

“We (retail investors) were butchered on every expiry day,” said Kejriwal, but he refuses to blame only proprietary trading firms for the F&O losses that retail traders accumulate.

“Now we have a name to blame but retail losses and Jane Street are incidental. Retail traders who do not have deep pockets or expertise should not trade in F&O. Option trading is not easy because the last half hour trading requires a lot more skillsets,” he said.

Apps which explain F&O trading via short videos also make it seem easy, while the truth is far from it. Baliga believes that the confidence to engage in high-risk trading comes from the easy money made by retail investors during the bull run.

“A lot of new investors have come into a trending market where it is easy to make money. Beginner’s luck is the worst thing to happen to new investors. First-time investors must lose money to understand markets. While retail investors cannot do deep research, they can always rely on common sense to invest,” advises Baliga.