Moneycontrol Pro Panorama | How Jane Street played the market -- and how to fix it

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In a turn of events that has stirred the trading community, the market regulator SEBI recently unveiled the practices of Jane Street, confirming long-held suspicions about market manipulation by major players. With vast resources at its disposal, Jane Street had been executing a sophisticated intraday index manipulation strategy, leveraging both cash and options segments to bend the market to its will.

What caught the public’s attention, however, was the way it allegedly orchestrated these manoeuvres through various entities. Indian traders found themselves in a precarious position, incurring losses while traders from Jane Street enjoyed substantial profits.

Jane Street also avoided tax obligations in India. It incurred losses in its Indian entities while the foreign ones reaped profits. For every rupee lost locally, these entities garnered profits more than 10 times abroad. The fallout was two-fold, as not only did individual Indian traders suffer, but the government also faced significant tax revenue losses.

This episode served as a crucial lesson in revealing systemic loopholes within the market's framework. It also spotlighted the vulnerabilities in the index construction, where a select few stocks were manipulated to sway the entire index. Many now argue that SEBI and the exchanges must revisit and strengthen these structures to prevent the recurrence of such incidents. The recent decision to omit smaller indices—which were easier to manipulate—from weekly expiries marks a step in the right direction.

Santosh Pasi, the founder of Sonic Alpha, weighed in, advocating a broader array of constituents within the index. He argued that increasing the number of stocks would deter manipulation, thereby imposing a prohibitive cost on any entity attempting to distort the market. The benchmark index currently represents only about 55 percent of the overall market capitalisation of Indian markets, with the BSE Sensex lagging even further behind.

Pasi also suggested reevaluating how various entities, especially those with shared promoters and directors among Indian companies and foreign portfolio investors (FPIs), are classified. By treating both groups as FPIs when trading in India, all necessary FPI trading rules would apply, thwarting intraday cash position squaring that fosters manipulation.

Pasi also called for setting limits on cash market trading volumes based on a percentage of market-wide traded value. In Jane Street’s case, their involvement surged to 15-25 percent of the market-wide traded value. Implementing similar restrictions as those in the options segment could significantly raise the manipulation costs.

While concerns circulate about potential volume declines if firms like Jane Street face strictures, many believe that such sacrifices are necessary for a more genuine market movement. The void left by FPIs could likely be filled by retail and proprietary traders who had exited the market after suffering due to manipulation.

As the market braces for the impact, the first expiry following SEBI's interim order (on Tuesday, July 8th) will be a pivotal moment. Although trading volumes might initially dip, traders will be cautiously exploring the waters with reduced activity over the coming weeks. However, with time, as market movements stabilise and option prices gradually decay, a return to higher volumes seems plausible.

SEBI’s decisive action in highlighting these malpractices is commendable, but the real challenge lies ahead: establishing comprehensive regulations that safeguard against future exploitation of such loopholes in the system.

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