The Securities and Exchange Board of India (SEBI), a significant regulator in the capital market, recently issued a discussion paper on regulating Algorithmic or Algo Trading. This form of trading uses automatic execution and logic to facilitate transactions in the Indian economy.
Understanding Algorithmic Trading
Algorithmic trading functions based on algorithms that leverage user data, behaviour, and usage patterns to execute specific commands. These orders are generated at incredible speeds using mathematical models and automated execution. Traders often benefit from even a split-second faster access, which can yield substantial gains.
The underlying system behind algo trading monitors live stock prices and initiates an order when certain criteria are met. This feature frees traders from manual order placement and tracking live stock prices. It accelerates the process of order execution within seconds, enabling more trades due to reduced manual monitoring.
SEBI’s Proposed Regulatory Framework for Algo Trading
SEBI has considered creating a regulatory framework governing algo trading. It emphasises that all orders generated from an Application Programming Interface (API), should be regarded as an algo order. Additionally, SEBI proposes that these orders should be subject to control by the stockbroker and tagged with a unique algo ID provided by the stock exchange.
Moreover, each algo strategy should receive approval from exchange and require certification by Certified Information Systems Auditor (CISA) or Diploma in Information System Audit (DISA) auditors. All such algorithms developed need to run on broker servers, facilitating client order control, order confirmations, and margin information. A two-factor authentication is proposed for every system granting access to investors for any API/algo trade.
Concerns for Market and Investors
SEBI expresses concern over the risk imposed by unregulated and unapproved algorithms. They can potentially be used to manipulate the market systematically and lure retail investors with the promise of higher returns.
Currently, exchanges approve algos submitted by brokers. However, for algos deployed by retail investors, neither the exchange nor the brokers can identify if a trade is an algo or non-algo trade. Moreover, the potential losses can be vast for retail investors since third-party algo providers are unregulated, lacking any investor grievance redressal mechanism in place.
Significance and Implications of Proposed Framework
The proposed regulatory framework aims to protect retail investors, boost their confidence in algo trading, curb price manipulation, and empower brokers to up-scale their technological prowess.
However, concerns arise as the process may make it tedious for brokers to get requisite permissions from stock exchanges. This could lead brokers to stop using the API system, negatively impacting the development of the market.
Role of Application Programming Interface
Many brokers in India now provide their clients with API access, enabling a connection between data providers (stock brokers) and end-users (clients). These APIs are used by investors to automate their trades. Despite this, brokers are presently unable to distinguish between algo and non-algo orders emanating from an API.
Moving Forward with Algo Trading Regulations
Regulations often aim to eliminate threats to a particular market, sometimes at the expense of stifling innovation. It’s crucial that regulators understand algorithms’ operations and retain the flexibility to engage in new legislation as required.
