Pirate algos front run bulk deals, leave brokers, fund managers fuming

Chori ho gaya (it has been stolen) is the market lingo for the shares that the buyer in a bulk deal does not receive. Bulk deals are negotiated beforehand between the buyer and seller and then entered into the trading system. Some shortfall is a common occurrence because a part of the block will get matched with other buy orders which are already present in the system.

But what has changed of late is the organized targeting of bulk deals by smart algos. Market players say that previously buyers in negotiated trades had to make peace with a loss of anywhere between 5-10 percent of the quantity.

“That number is now regularly as high as 15-20 percent, and sometimes even more,” said a dealer at a mutual fund, adding that there have been instances where as much as 50 percent of the quantity is scooped up by the algos.

Bloodless coup

In all fairness, the developers of the smart algos are not doing anything illegitimate as long it is only the algos that are at work. These algo trading firms deploy what are known in market parlance as depth-seeking algorithms. The algos analyse the quantity of buy and sell orders at various price levels in the exchange’s order book and then place orders at different price levels, factoring in market conditions, price movements and liquidity.

This is a sea change from the not-so-distant past when traders looking to front run bulk deals had to have inside information of the quantity and the price. They would then put their bids a few paise lower and snatch a small portion of the deal.

1-2-3 ineffective

The depth seeking algos are so swift that the usual 1-2-3 technique used in negotiated trades is no longer effective. The 1-2-3 technique was an improvisation by the brokers in the late 90s when SEBI scrapped the window for negotiated deals, saying it was being misused to give a false picture to retail investors.

In the 1-2-3 system, the buying and selling broker finalise the deal over the phone, feed their respective orders into the system, and at the count of three, both brokers simultaneously hit ‘enter’ on their key boards.

“Even a difference of a few milliseconds is enough for the algo to sneak in and take a bite off the block,” said the mutual fund dealer quoted above.

Not all kosher?

But a section of market players suspect that it may not be smart algos alone at work. The bulk deals are not being nicked by high frequency trading (HFT) strategies, which flip the position in or minutes for a few paise higher. These deals are being nicked by algo strategies which often hold the positions for hours, and at times even overnight.

“Sometimes there is reason to believe to that somebody is tipping off these algo firms,” said another dealer. “The leak could be either from the selling or buying broker’s end, or it could even be the investors party to the deal” he said.

The follow-on effect

Whenever a big block of shares changes hand, trading volumes in that stock shoots up. That is because it is usually large investors that are on both sides of the trade. Till a few years back, other traders would jump into the fray depending on the reputation of the buying and selling parties. For instance, if the seller was a big fund house and the buyer was not a well-known name, the stock price would weaken after a bulk deal.

Similarly, an FII selling and local MF buying generally used to be seen as a trigger to sell. Same was the case for stock sale by promoters, irrespective of who was the buyer. Now that no longer seems to be the case. Mutual funds today are viewed with more respect than FIIs and some HNIs have become institutions in their own right. Besides alternative investment funds and portfolio management services firms too have become major players.

Congrats, it's a buy

In a raging bull market like the one underway right now, any bulk deal is seen as a reason to buy the stock on the grounds that there is enough demand for the stock even if some large investors are selling out.

As a result, stock prices more often than not rise after a bulk deal, even if the spike may last just for that session or at best the following day.

The alternative

To avoid leakage of shares during a bulk deal, the buyer and seller can always choose to use the block deal window, which is open twice during the day. But the price of any deal done in the block window has to be plus or minus one percent of the reference price decided by a volume weighted average rate formula. If the price is not within the price band, the deal has to be executed in the normal trading window.

Block deal window requires full disclosure, something which one of the parties to the deal may not be comfortable, if it either happens to be an entity related to the promoter group on the selling side or an HNI looking to build a position without drawing the market’s attention.

Under the radar?

Market players say that at times the dedicated block trade window is avoided because one of the fund managers or the brokers involved may want to front run the deal.

“Even if the algos are smart, the firm taking a bite of the bulk deal needs to be certain that it will be able to exit that position by the end of the day or at most in the next couple of days,” said one of the dealers quoted above.

At the same time, it is not that algo firms front running bulk deals make money on every trade. There have been instances when they have had to exit positions at a loss or just breakeven.

One Mumbai-based algo firm in particular has been at centre of market chatter given the regularity with which it has been able to squeeze itself into bulk deals. “Maybe it is a very intelligently written algo that always snaps up the best deal, but sometimes it seems like too much of a coincidence,” the dealer said.

Affected parties

The nicking of bulk deals may be legitimate, but if the shortfall in shares is higher than usual, the buying broker suffers financial as well as reputational loss. Because of that, few are willing to talk about the matter openly. And in the case of mid and small cap stocks, it leaves the fund managers fuming because large blocks are hard to come by.

But in a few cases, this trend has had some unintended consequences as well. And the brokers on the selling side appear to be benefitting from it.

For instance, if a client wants to sell a couple of million shares, and demand from institutional investors is for less than that quantity, the broker will still go ahead with the sale. With bulk deal seeking algos on the prowl, chances are that one of them may end up gobbling the portion for which there was no demand from institutions.

Global problem

There is no easy fix to this trend. Globally too, front running of bulk deals is common. In the US, the Securities and Exchange Commission has been probing investment bank Morgan Stanley for nearly two years if it had improperly tipped off favored hedge-fund clients to big blocks of stock coming on the market. According to a report last month by financial website semafor.com, a possible settlement with Justice Department and Securities and Exchange Commission would involve a fine of between $500 million and $1 billion. The bank fired several employees and pulled back from the block trading business, losing market share to rivals, the report added.