[Editorial] SEBI’s Plan to Regulate Algo Trading

What is algo trading?

  • Algo trading or algorithmic trading is the use of advanced mathematical models for trading in stocks.
  • It uses pre-programmed computer strategies to buy and sell stocks based on a set of parameters like specific market conditions or patterns. Hence, it is also called automated/ programmed trading.
  • It has been in use in India since 2008. But its widespread use by retail traders started in the past 5 years.
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How does algo trading work?

  • The main objective of algo trading is superfast execution of orders. While humans take several seconds to execute the buy and sell orders, algos can do it in split-seconds. This speed of execution has potential to increase the trader’s gains.
  • Before algos were introduced, retail traders had to be physically present at the broker’s office to execute trades or call up their brokers for it.
  • With the advent of algos, traders connect these pre-programmed algos to a broker’s trading terminal. This terminal is linked to stock exchange server. This means that the also run on the broker’s system.
  • The algo monitors the live stock prices and when the criteria are fulfilled, it automatically initiates an order on the investor’s account.
  • In mobile trading, which is also a type of algo trading, orders are executed through mobile apps.

Why is it significant?

  • In the Indian stock markets, some 50% of daily trading volume is through algo trading.
  • Many 3rd party algo programmers are selling their buy-and-sell strategies to retail traders.
  • Many retail traders are using these strategies- being sold as off-the-shelf products.

How does SEBI plan to regulate it?

  • SEBI has proposed the creation of a regulatory framework for algo trading.
  • According to SEBI, all orders from an API (Application Programming Interface) is to be considered as an algo order. These orders are subject to stock broker’s control.
  • The APIs used for algo trading are to be tagged with a unique algo ID. This ID is to be provided by the stock exchange that approves the algo.
  • The stock exchange also has to approve each algo strategy- whether used by the client or the broker.
  • The algo strategies have to be approved by CISA (Certified Information Systems Auditor)/ DISA (Diploma in Information System Audit) auditors.
  • On the stock exchanges’ part, a system has to be developed to ensure that only the approved algos are being deployed.
  • 2 factor authentication is to be used in every system which is used by the investor for algo trading.

Why is SEBI planning to regulate it?

  • Though broker terminals are regulated and monitored by SEBI and the stock exchanges, algo programs aren’t subject to such rules and regulations.
  • Such unregulated algos could be misused to lure investors with guarantees of higher returns and for systematic market manipulation. This poses a risk to the market.
  • In the absence of regulation, a failed algo strategy could mean huge losses for retail investors. Meanwhile, programmers are selling algo strategies like assured return products.
  • Algo trading has had its share of controversies. Eg: in 2015, it was reported that the NSE gave preferential access to some algo traders.

What is the way ahead?

  • Market experts opine that algo trading will aid retail investors, especially those who aren’t engaged in stock trading full-time. It will also deepen the stock markets.
  • It is also opined that introduction of restrictions would hinder market development especially as brokers may stop using API system given the difficulty in getting the permissions from stock exchanges. Many strategies would fail to get an approval because of their complex nature.
  • Some are hesitant about the proposal as submitting the strategies for approval would mean revealing the formula.
  • But, unregulated and unapproved algo trading poses a risk to the market. This is added to by the lack of regulation of 3rd party algo providers and algo vendors. There is also a lack of investor grievance redressal mechanism.
  • A section of the market community opine that the SEBI’s proposal is a step in the right direction. Regulation will protect investors’ interests and boost their confidence to take up algo trading.
  • The risks of price manipulation and heavy losses for investors can be avoided if a set of rules is put in place.

Conclusion:

During the past 5 years, algo trading has taken roots in the Indian markets and is aiding retail traders. However, the lack of regulation leaves it open to misuse. Regulation would protect investors’ interest and could be a blessing in disguise for brokers to improve their technological prowess and to expand their client base.

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