Exclusive: Brokers lure algo traders with prop book for higher leverage, fuel options mania

The share of proprietary trades in overall derivatives turnover (futures plus options) rose to 53.1 percent in FY23 from 48.8 percent the previous year. For the last three months of FY23, the average monthly share was as high as 56 percent. This is a massive jump from just three years ago, when the share of proprietary trades as a percent of total turnover was barely 33 percent.
In index options, the share of proprietary trades has climbed to 45.1 percent in FY23 from 42.9 percent, with the average for the last three months being 48 percent.

In stock options, the share of proprietary trades has risen to 56.2 percent in FY23 from 49.7 percent the year before, with the average for the last three months being close to 58 percent.

The deal

Derivative traders say many of the lesser-known brokerages have entered into arrangements with options traders who use algorithm-driven strategies and clock high volumes. The brokers offer their application programming interface (API) feed to their clients giving them access to real-time prices. This allows the clients to run their algorithms on the broker’s trading platform.

“In such an arrangement, the broker can give a much higher leverage to their clients, than would otherwise be possible under the regulations,” said a derivatives trader familiar with the arrangement.

“For instance, the broker will collect Rs 2 crore as margin money from the client, and then allow him to take an exposure 10 times that or whatever number the broker is comfortable with. The broker has money lying in his bank account, against which he will get bank guarantees issued and deposit it as margin with the clearing house. The broker will then charge the client interest for funding his exposure,” the trader said.

Besides funding charges and brokerage, there are profit-sharing arrangements as well between the broker and the clients, depending on the level of risk the broker or client is willing to share.

“The return on investment for the broker on such an arrangement is around 16 percent, with profit sharing, it could go as high as 25 percent,” the trader said.

Tax implications

The question then is: how do the brokers manage their tax liability if their clients keep making money? After all, the profits will reflect in the broker’s books since these are being shown as proprietary trades.

“That can be managed easily; since it is business income for the broker, he can set off a part of his profits against business expenses. And the arrangements with the clients show them to be employees or consultants who are getting paid for their services. The payout is done after taking into account the tax liability, funding costs and brokerage,” the trader quoted above said, adding that tax evasion was not the motive here. “All the pay-outs are done through banking channels.”

Downside protection

.But what if the clients lose money?

“The brokers are selective in offering this service; they check the track record of potential clients before signing them up,” said another derivatives trader.

“Also, the algo strategies are not high risk ones on the face it; if there is an extreme market event, that is another matter. Because they algorithm driven, the losses are pre-defined. And in the event of losses, the broker always has access to the margin money deposited by the clients,” said the trader.

Two-tier market

This has led to a situation where brokers using their proprietary books are at an advantage compared to other brokers who choose to play it by the books.

Large high-profile broking firms cannot offer a service like this for two reasons; one, SEBI regulations do not allow them to fund their clients, and second, they can’t cut customised deals with individual clients, which the lesser-known brokers are in a position to offer, said people from the broking industry.

Options mania

In FY20, the share of retail and proprietary trades combined as a percentage of the total turnover in index options was around 60 percent. That has risen to over 80 percent now. In the case of stock options, the corresponding figure has risen from 62 percent to 88 percent over the last three years.
Long time derivative traders say that majority of the new entrants do not understand risk management and tend to focus only on possible returns. That has worked well for most part in the last three years because the market has not seen the kind of extreme intra-day moves like in 2004, 2006, 2008, 2012 and 2020 when trading was halted after the indices crashed to lower end of the intra-day circuit filter. In May 2009, trading was halted after indices hit the upper end of the intra-day circuit filter.

In theory, options traders are supposed to be using hedging strategies that minimise risks in the event of an adverse price move. But the reality is different. There is a cost to hedging and too much hedging also limits potential profits. So, most traders prefer to use a stop loss. On paper, stop losses should limit traders’ losses as well as the risk to the system. But that is assuming there will always be a counterparty to the trade when the price hits the stop loss limit. In the event of extreme market moves on either side, there is every possibility that counterparties will simply vanish, thus resulting in much bigger losses for traders. The losses incurred above whatever margin the clients have deposited with the brokers will be hard to recover for the broker as many clients may simply refuse to pay up.

In addition, the widespread use of algorithmic trading strategies can exacerbate sharp swings on either side as high frequency traders move in to make a quick profit. And the outcome can be disastrous even for the smartest of players.