Why Jane Street’s ‘basic arbitrage’ defense doesn’t work
Business Business: India’s capital market regulator, SEBI, made headlines in the global financial media with its shocking order against trading firm Jane Street last week. The order accused the New York-based high-frequency trading firm of running a “sinister scheme” to make huge profits by manipulating the Indian stock and derivatives markets. It has banned the Jane Street group from any activity in the stock market and asked it to return “illicit earnings” of Rs 4,843 crore. What has stunned global markets is the pile of detailed details submitted by SEBI to prove the alleged “manipulation”.
At the time of this writing, Jane Street has not contested the order in India’s Securities Appellate Tribunal. But it has denied the allegations and sent an internal memo to employees; some outlines of its defence can be understood from this leaked memo.
A relevant excerpt from the memo is as follows:
“The order states that it is ‘particularly instructive’ to consider the first eight minutes of trading on January 17, 2024 in order to understand the ‘purpose and design’ of our options strategy, called ‘intra-day index manipulation.’ These eight minutes reflect basic index arbitrage trading, which many of you may know as a basic and common mechanism of financial markets that keeps the prices of related instruments in line. One can easily see that there was a large gap between the price of the BankNifty Index (NSEBANK Index on Bloomberg) reflected in the options markets and the price implied by the stock levels. Jane Street (presumably along with other market participants) traded in the corresponding direction to bridge that gap and bring the two markets more in line with each other.”
In simple terms, Jane Street claims that it was only doing index arbitrage trading, i.e. there is a price difference between the price of a stock as indicated in the liquid options market and the less liquid cash and futures markets, and firms like Jane Street do arbitrage trading to bridge this gap.
Arbitrage trading means buying the same stock or its derivative equivalent in a market where it is cheaper and selling it where it is expensive. But SEBI is arguing, based on detailed data, that Jane Street did not simply take opposite positions in the cash and options markets. Jane Street (JS) forced the prices of the stocks to move in a direction favourable to its position in the options market and ensured that they became profitable. In other words, it manipulated the prices.
SEBI points to two types of manipulation strategies. Let us look at the strategy mentioned in the JS memo, the “intraday index manipulation strategy”, which SEBI says Jane Street did on January 17, 2024, and 14 other days. In the first half of the day, the JS group bought the Bank Nifty index and its underlying stocks for Rs 4,370 crore. During these hours when it was making its purchases, it accounted for 15%-25% of the market-wide gross traded volume (GTV) in these stocks and futures. In fact, its turnover was 3 to 4 times more than the second-largest trader.
In other words, the Jane Street group was not only buying stocks in the cash market but also pushing the stock prices up, and the Bank Nifty index was also moving upwards, prompting retail investors to take long positions (i.e. buying calls and selling puts) in the options market. At the same time, apparently unbeknownst to the market, JS was taking a massive short position of Rs 32,115 crore by buying puts and selling calls on the Bank Nifty index in the options market.
