• The Securities and Exchange Board of India (SEBI) has proposed a regulatory framework for algorithmic trading (algo trading) by retail investors to make such trading safe and prevent market manipulations.

• In its consultation paper, the regulator has proposed a framework for algo trading done by retail investors including use of Application Programming Interface (API) access and automation of trades.

• Experts say that the proposal of treating all orders emanating from API as algorithmic or algo order can restrict the growth of such trading in India.

• SEBI has sought comments from the public till January 15 on the proposal.

What is algo trading?

• Algorithmic trading (algo trading) refers to any order that is generated using automated execution logic.

• Algorithms have become such a common feature in the trading landscape that it is unthinkable for a broker not to offer them because that is what clients demand. These mathematical models analyze every quote and trade in the stock market, identify liquidity opportunities, and turn the information into intelligent trading decisions.

• Algo trading includes any type of automated rule based trading where decision making is delegated to a computer model. 

• Algorithmic trading became a popular tool after technological progress transformed the way assets are traded.

• High Frequency Trading (HFT) is a type of algorithmic trading which is latency sensitive and is characterised by a high daily portfolio turnover and high order-to trade ratio (OTR).

• Generally, the features of algorithmic trading include using a defined set of  instructions in the form of algos to generate trading signals and placing orders.

• The algo trading system automatically monitors the live stock prices and initiates an order when the given criteria are met. 

• This frees the trader from having to monitor live stock prices and initiate manual order placement. 

• Algo trading cuts down transaction costs, and allows investment managers to take control of their own trading processes. 

• The main objective of algo trading is not necessarily to maximise profits but rather to control execution costs and market risk.

• However, lack of control has led to systemic risks. Faulty algorithms can cause huge deviations from healthy prices.

• It has been proved in the past that algo trading and HFT can be used to manipulate markets using techniques like quote stuffing, layering (spoofing) and momentum ignition. Evidence suggests that market manipulation algorithms lead to decreased liquidity, higher trading costs, increased short term volatility, impact performance and fill rates, and massive price moves backed by false volume.

What is SEBI?

• The Securities and Exchange Board of India (SEBI) was established on April 12, 1992 in accordance with the provisions of the Securities and Exchange Board of India Act, 1992.

The main objectives of SEBI are:

1) To protect the interest of the investors.

2) To regulate and promote development of securities markets in India. 

The main functions of SEBI include:

1) Registration, regulation and supervision of intermediaries operating in the securities market.

2) Promoting and regulating self-regulatory organisations.

3) Prohibiting fraudulent and unfair trade practices relating to securities markets.

4) Calling from or furnishing to other authorities, whether in India or abroad, such information as may be necessary for the efficient discharge of its functions.

Why SEBI proposes a regulatory framework?

• It is observed that Application Programming Interfaces (APIs) are being used by the investors for automating their trades.

• The advent of platforms that are selling algorithmic strategies according to the needs of the investor that can be used off the shelf or applications which are allowing investors to create algo strategies using web-based strategy builder are acting as catalyst to this automation of trades being done by the investors.

• While the services of these third-party applications/algo providers/vendors are being increasingly used by investors (especially retail investors), it is observed that such algos are being deployed without taking requisite approvals from the exchanges as per the extant provisions. 

• Currently, exchanges are providing approval for the algo submitted by the broker.

• However, for the algos deployed by retail investors using APIs, neither exchanges nor brokers are able to identify if the particular trade emanating from API link is an algo or a non-algo trade.

• This kind of unregulated/unapproved algos pose a risk to the market and can be mis-used for systematic market manipulation as well as to lure the retail investors by guaranteeing them higher returns. The potential loss in case of failed algo strategy is huge for retail investor.

• Since these third-party algo providers/vendors are unregulated, there is also no investor grievance redressal mechanism in place.

What are the main suggestions?

• All orders emanating from an API should be treated as an algo order and be subject to control by stock broker and the APIs to carry out algo trading should be tagged with the unique algo ID provided by the stock exchange granting approval for the algo.

• Broker needs to take approval of all algos from the exchange. Each algo strategy, whether used by broker or client, has to be approved by exchange and as is the current practice, each algo strategy has to be certified auditors.

• Also, brokers will deploy suitable technological tools to ensure that appropriate checks are in place to prevent unauthorised altering or tweaking of algos. They need to have adequate checks in place so that the algo performs in a controlled manner.

• All algos developed by any entity have to run on the servers of broker wherein the broker has control of client orders, order confirmations, margin information among others.

• Brokers can either provide in-house algo strategies developed by an approved vendor or outsource the services of third party algo provider/vendor.

• Stock brokers should be responsible for all algos emanating from its APIs and redressal of any investor disputes.

• Obligations of stock broker, investor and third party algo provider need to be separately defined. Stock broker is responsible for assessing suitability of investor prior to offering algo facility. No recognition shall be given by the exchange to the third party algo provider/vendor creating the algo.

• Two factor authentication should be built in every such system which provides access to an investor for any API/algo trade.

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