Algo Trading Regulations: Will They Hit Adoption of this Futuristic Technology?

On December 9, capital markets regulator Securities and Exchange Board of India (SEBI) came out with a consultation paper on regulating algorithmic trading (algo trading) done by retail investors. The regulator has invited comments from all industry participants and the public on algo trading. The intent of this move is to make algo trading safe for retail investors and to prevent market manipulations. 

Post this move, the investment circles are aflush with discussions around the likely pros and cons of this decision. Let us try to decipher this move in detail.

To start with, let us understand what is algo trading? Then we will come to the more important topics of why it needs to be regulated and what is our take on this development.
 

What is Algo Trading?

Algo trading tool uses computer programs to place a trade based on predefined rules and principles. The computer program uses a set of instructions that helps make trading decisions at a pace that would be difficult for a human trader to achieve. 

Simply put, algo trading monitors live stock prices and executes a trade upon fulfillment of a specific criteria.
This method frees the traders from having to monitor stock prices on the go and initiate an order. Other benefits of algo trading include enhanced liquidity in markets and adoption of more systematic approach to trading.

Application Programming Interface or API is a set of programming codes that queries data, parse responses, and sends instructions between one software platform and another. APIs are used extensively in providing data services across a range of fields and contexts.
 

What are the key recommendations by SEBI?

1) All orders from an API should be treated as algo orders and will be subject to control by the broker.

2) APIs should be tagged with the ‘Unique Algo ID’ provided by exchange, granting approval for the algo.

3) Brokers need to take approval of all algos and algo strategies from the exchange, whether used by broker or client.

4) Each algo strategy has to be certified by Certified Information Systems Auditor (CISA)/ Diploma in Information System Audit (DISA) auditors.

5) Stock exchanges have to develop a system to ensure that only those algos which are approved by the exchange and having unique algo ID provided by the exchange are being deployed.

6) Brokers shall deploy suitable technological tools to ensure that appropriate checks are in place to prevent unauthorized altering/tweaking of algos.

7) All algos developed by any entity have to run on the servers of brokers wherein the broker has control of client orders, order confirmations, margin information, etc. 

8) Stock brokers need to have adequate checks in place so that the algo performs in a controlled manner.

9) Stock brokers can either provide in-house algo strategies developed by an approved vendor or outsource the services of third party algo provider/vendor by entering into a formal agreement with each third party algo provider/vendor whose services are being availed by the broker.

10) Stock broker is responsible for all algos emanating from its APIs and redressal of any investor disputes.

11) Obligations of stock broker, investor and third party algo provider/vendor need to be separately defined.

12) Stock broker is responsible for assessing suitability of investors prior to offering algo facilities.

13) No recognition shall be given by the exchange to the third party algo provider/vendor creating the algo.

14) Stock brokers shall ensure that only those third party algo providers/vendors, with whom broker had entered into an agreement with, shall use the name of the broker as part of their testimonial, provided exchange prescribed advertisement guidelines are met.

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

16) The software to be used to create the strategies should be approved by the exchange.

17) Stock brokers shall have to include a specific report on algorithm checks implemented by them as a part of Annual System Audit Report submitted to the exchanges and format for the same shall be prescribed by the exchanges.

Our take

We welcome SEBI’s decision to regulate algo trading as the intentions of safeguarding interests of retail investors, preventing manipulation and enhancing transparency are on target. We support measures such as two-factor authentication, which once implemented will help in preventing misuse of customers’ account. In other words, customers will be in full control of their own accounts.

The suggestions made to ensure brokers have well defined checks and balances in place are also in the spirit of preventing misuse and are the need of the hour. However, some measures suggested in the regulator’s consultation paper seem to be based on faulty premises. For instance, all orders implemented through APIs should be considered as algo.

APIs form less than 3% of 5paisa’s total volumes and within this 3%, orders via algo are rather miniscule. A lot of our partners and fintech players are provided with the API facility. These firms may not necessarily be an algo platform. Some have an investing platform, others provide research advisory, and some provide analytical tools.

All these tools make trading/investing easier for the end-user. By providing users with APIs, brokerages are trying to expand the market and also empower new-age fintechs to provide quality services as well as high convenience to the end users.

They are playing an important role in enhancing the knowledge, engagement and awareness of the customers, driving them to take more informed decisions. Over-regulation and harsh restrictions on such transactions might pull the industry backwards in terms of technology, creating hurdles in leveraging the full potential of such high-end technological tools.

Earlier, end customers had limited option other than platforms provided by brokerages to undertake transactions in the market. With the advent of APIs, people can undertake trades at a time and platform of their convenience.

For instance, if an end user is using the charting tools provided by specialized fintechs, he/she can trade directly from that platform, instead of 5paisa’s platforms. In short, APIs are pivotal in driving scale of investing, particularly among retail customers.

To conclude, regulating algo trading will make the process more streamlined. However, the regulator has to walk a tight rope to ensure that too much regulations don’t come in the way of growing the industry via technologically advanced tools.

Also Read:-

Why Should You Do Algo Trading?