JSE introduces new algorithmic trading rules

In May the Johannesburg Stock Exchange (JSE) announced new rules designed to ensure more stringent oversight of how brokers and trading firms deploy “algo-trading” techniques on the exchange. Algorithmic trading involves the use of technology such as computer programs or artificial intelligence (AI) to allow traders to buy and sell financial assets automatically, according to predefined rules. Rather than relying on humans to watch over the market and manually place orders, which means potentially missing out on strong market opportunities, algo-trading allows firms to take advantage of beneficial prices automatically when they become available. The proliferation of this technology has been welcomed by some, with one analysis in the American Finance Association’s Journal of Finance noting that “by reducing the frictions and costs of trading, technology has the potential to enable more efficient risk sharing, facilitate hedging, improve liquidity and make prices more efficient.” Indeed, algo-trading has become increasingly prominent in recent years as traders seek to leverage new technology to make higher profits: some industry estimates suggest that up to 75% of global equity trading is now conducted by algorithms. While JSE-specific data is not available, academics from the University of the Witwatersrand have noted that “in the last two decades, this new technology has gained traction globally and now accounts for the majority of the trading volume on the JSE.” New rules for robots In this context, the JSE is seeking to strengthen its oversight of algorithmic trading by forcing firms to impose mandatory risk controls for algo-traders: brokers and trading houses using algorithms must have robust pre-trade controls in place to mitigate the risk of erroneous orders. Firms must also ensure any algorithms they use are properly designed, tested, monitored and subject to consistent international oversight – with accountability for this resting with senior management. Furthermore, brokers that allow clients to connect directly to the exchange must now implement appropriate controls and remain ultimately responsible for their clients’ algo-trading activity. These rules have been elevated from “technical directives” into the JSE’s formal rulebook, which also gives the exchange greater powers to oversee algo-trading activity and crackdown on any irresponsible behaviour. The changes bring the JSE in line with international best practices, with the new controls similar to those which are already in place in markets such as the United States and Europe. Algorithmic trading: things can go wrong M’khuzo Mwachande, an investment banker based in Cape Town, tells African Business that these new rules have come about as “regulators are increasingly focused on operational and market integrity risks, including erroneous or “fat finger” orders, runaway algorithms generating excessive order flow, spoofing [placing orders with no intention of executing them], layering [creating a false impression of supply or demand], quote stuffing [flooding the market with orders and cancellations], artificial price movements and false appearances of liquidity or trading activity.” However, he emphasises that “the core objective [of the JSE reforms] is not to stop algorithmic trading. “It is to ensure that if a rogue algorithm, software malfunction or poorly supervised trading strategy causes disruption, there is a clearly accountable party responsible for managing that risk.” Global markets exposure Japheth Munywoki, CEO at Johannesburg-based investment banking firm Goodson Capital Partners, tells African Business that algo-trading is currently more prominent on the JSE than other African exchanges – making it particularly important the regulator takes steps to mitigate potential risks. He says the fact that the JSE is home to around 135 cross-listed companies – firms that are also listed on exchanges in New York, London, or Toronto – means that Johannesburg is more exposed to spillover effects from algo-trading in those larger global markets. “The key issue is that we are not a market that operates in isolation,” he says. “Since we have cross-listings with other exchanges, then we need to manage the risks that arise from other markets. “The JSE is much more exposed than other markets in Africa as it is a bigger, more developed and more efficient market as opposed to the rest of the continent,” Munywoki adds. “That is why it is so important the JSE has brought itself into line with international best practices on managing algo-related risks.” While algo-trading is not yet as common on Africa’s other major stock exchanges – hence the JSE being the first African exchange to bring in specific rules around algo-trading – the rise of this new technology could potentially pose challenges for regulators and market participants across the continent. Vulnerable to irresponsible trading As African stock exchanges are much less liquid than global markets – shares worth several hundred billion dollars can be traded in a day on the New York exchanges, compared to a reported typical $1.4bn a day in Johannesburg, for example – they are more vulnerable to irresponsible trading. Mwachande explains that “developed markets such as those in the US and Europe have very deep liquidity pools, large numbers of participants, sophisticated market-makers and extensive surveillance infrastructure. While algorithmic trading dominates trading activity in those markets, there are also multiple layers of controls designed to absorb shocks… Many African exchanges, in contrast, have thinner trading volumes, fewer active participants and wider bid-offer spreads,” he adds. “In such environments, a malfunctioning algorithm or poorly controlled trading strategy can have a disproportionately large effect on prices and liquidity.” “The JSE faces the greatest exposure at the moment simply because it is Africa’s most technologically advanced and liquid market and attracts the largest institutional and algorithmic trading flows,” Mwachande tells African Business. “However, smaller exchanges may actually be more vulnerable if algorithmic participation increases because they generally have fewer safeguards, less surveillance capacity and significantly lower liquidity.” Can regulation keep up with reality? As financial markets across the continent continue to modernise, ensuring that regulation and oversight is updated at the same rate as technological change will be vital for the JSE and other African markets. Munywoki notes that “the key issue is making sure that we do not stifle innovation in terms of technology for trading. Algo-trading has been an important innovation for improving liquidity and price discovery, as well as securing tighter spreads. We need to encourage that while protecting investors and market integrity.” Mwachande believes that this is not a binary choice: “in fact, robust controls can encourage innovation because institutional investors and market participants are more willing to deploy advanced trading technology when they have confidence in the integrity and resilience of the market.” “The broader story is that African capital markets are becoming more sophisticated. The presence of algorithmic trading is actually a sign of market maturation. The challenge for regulators is not to prevent technological progress, but to ensure that market infrastructure, oversight and risk controls evolve at the same pace as the technology being deployed.”