OPINION Why Jane Street’s ‘Basic Arbitrage’ Defence Doesn't Wash

These conditions will remain in effect until the market watchdog completes its ongoing investigation

India's capital markets regulator, SEBI, grabbed global financial media headlines with its stunning order last week against trading firm Jane Street. The order accuses the New York-headquartered high-frequency trading firm of a "sinister scheme" to manipulate Indian stocks and derivatives markets to make a ton of profits. It bans the Jane Street group from any activity in the stock market and has asked it to pay back Rs 4,843 crore of "illegal gains". What has stunned the global markets is the mountain of granular detail that SEBI has presented to prove the alleged “manipulation”.

At the moment of this writing, Jane Street has yet to contest the order at India's Securities Appellate Tribunal. But it has denied the charges and has sent an internal memo to employees; some contours of its defence can be gleaned from that leaked memo.

Here's one relevant para from the memo:

"The Order says 'it is particularly instructive' to consider the first eight minutes of trading on January 17, 2024 in order to understand the 'intent and design' of our options strategy, which it calls 'Intra-day Index Manipulation.' Those eight minutes illustrate basic index arbitrage trading, which many of you will know as a core and commonplace mechanism of financial markets that keeps the prices of related instruments in line. One can easily observe that there was a large divergence between the price of the BANKNIFTY index (NSEBANK Index on Bloomberg) reflected in options markets and the price implied by the stock levels. Jane Street (presumably alongside other market participants) traded in a direction consistent with closing that gap and bringing the two markets more in line with one another."

In simpler terms, what Jane Street is claiming is that it was merely doing index arbitrage tradin,  that there tends to be a price differential between the price of a share indicated in the liquid options market, and the less liquid cash and futures markets, and companies like Jane Street do arbitrage trading to bridge the gap.

Arbitrage trading would mean buying the same stock or its derivative equivalent in a market where it is cheaper and selling it where it is expensive. But what SEBI is arguing with granular data is that Jane Street didn't merely take opposite positions in the cash and options markets. Jane Street (JS) forced the prices of stocks to move in a direction favourable to its positions in the options market and ensure they turned profitable. In other words, it manipulated prices.

SEBI points to two kinds of manipulating strategies. Let us look at the one referred to in the JS memo, “Intraday Index Manipulation Strategy” which SEBI says Jane Street indulged in on January 17, 2024 and 14 other days. In the first half of the day, the JS group purchased the Bank Nifty Index and its underlying stocks for Rs 4,370 crore. In these hours when it was buying, it accounted for 15%–25% of the market-wide Gross Traded Volume (GTV) in those stocks and futures. Indeed, its volume of trading was 3 to 4 times more than the second largest trader.

In other words, the Jane Street group wasn’t just buying shares in the cash market, it was moving the share prices higher, and the Bank Nifty Index also moved higher in tow, enticing retail investors to take long positions in the options market (i.e. buying calls and selling puts). Simultaneously, obviously unknown to the market, JS was taking massive short positions on Bank Nifty Index in the options market to the tune of Rs 32,115 crore, by buying puts and selling calls.

In late trade, SEBI again proves with data that the JS group sold all the bank shares and Bank Nifty index futures that it had bought in the morning. Again, its selling volumes constituted 25% to 37% of the market's total volume in the Bank Nifty Index futures and bank stocks in the last hour of trading. So the selling was large enough to force the price down so much that, at expiry, Jane Street's sell positions in the options market became hugely profitable.

On just that one day, Jane Street made a profit of about Rs 735 crore in the options trades, even if it made losses of Rs 61.6 crore in the cash and futures segment. SEBI has analysed 21 days of trading and computed JS's "illegal gains" at Rs 4,843 crore.

The heart of the argument between SEBI and Jane Street is whether this activity constitutes “basic arbitrage” or “market manipulation”. In this debate, at the moment SEBI’s arguments are clearly way more convincing.

In a normal basic arbitrage trade, the value of the shares bought in one market would broadly match the value of the shares (or their derivatives) in the other market. But in Jane Street’s case, the value of sells in the options market was seven times the value of the buys in the cash and futures market. Can this be “basic arbitrage”?

Secondly, the JS group was not merely buying or selling, it was leading the direction of the market with some heavy participation. In the morning of Jan 17, 2024, its purchases of bank stocks (constituents of the Bank Nifty) and its purchases of the Bank Nifty index futures, as said before, were a sizeable one-fourth of the gross traded value in these counters, enough to force the upward direction of the market.

Likewise, in the afternoon, when small traders were full with long positions, the JS group dumped its morning buys and again, by providing 25% to 37% of the traded volume, could force down the Bank Nifty index, to a point where its short positions became profitable.

Jane Street wasn’t just aligning prices in two different markets. It was dominating and deciding the direction and level of the market, per SEBI data. It was classic pump and dump at play. Can this be called “basic arbitrage”?

Jane Street, as a foreign-registered entity, cannot buy and sell its shares on the same day. It has to take delivery of shares. So it registered two entities in India: JS1 Investments Pvt Ltd and JS2 Investments Pvt Ltd. They do the buying in the morning and the selling in the afternoon in the cash and futures markets, and repeatedly post losses of a few million dollars, while its Singapore-registered associates, Jane Street Singapore Pte Ltd and Jane Street Asia Trading Ltd, play in the options markets where intraday squaring is permitted for foreign entities.

Why would any group open India-based entities only to consistently make losses? In this case, it appears their purpose was to drive the underlying share and index prices. Can such an arrangement, obviously to work around the law, be called “basic arbitrage”?

Jane Street is a bunch of highly intelligent mathematicians and algorithm builders. They would know that the volume in the Indian options market is about 350 times the volume in the cash market. They would know that when they bought the underlying shares of the Bank Nifty in the cash market for millions of dollars, they were accounting for one-third or one-fourth of the volume in these counters and would end up driving prices and sentiment at that time.

Also, SEBI proves that in the morning, when bidding up the prices, a bulk of the trades of JS were at levels higher than the last traded price (LTP). In the afternoon, when selling its positions, the bids were lower than the last traded prices (LTP), indicating an intent to drag down the index to a point where the options positions become profitable.

Can all this be explained away as “basic arbitrage trading”?

SEBI also quotes the Prohibition of Fraudulent and Unfair Trade Practices (PFUTP) Regulations, which clearly forbid such activity.

Regulation 4 (2) of the PFUTP says that

Dealing in securities shall be deemed to be a fraudulent or an unfair trade practice if it involves any of the following –

(a) knowingly indulging in an act which creates false or misleading appearance of trading in the securities market;

(e) any act or omission amounting to manipulation of the price of a security including, influencing or manipulating the reference price or benchmark price of any securities;

SEBI’s numbers and data seem to prove beyond reasonable doubt that the above regulations were violated by the Jane Street group.

As Alex Gerko, co-founder of rival algo-trading firm XTX Markets wrote:

“My first reaction based on morning headline alone was that it's probably the case of ‘It is not illegal to be smarter than your counterparties in a swap transaction’. However, if you read the allegations made in the SEBI filing, the whole thing appears to stink very badly. Alleged activity is clearly illegal in any country that has a financial regulator. Actually criminal in US (think jail time).”

Indian laws are similar.

Of course, the last word can only be said after one hears Jane Street’s defence at the appellate tribunal. But it does have a high bar to clear.