Algo Trading

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SEBI has released a consultation paper on algorithmic trading, or algo trading.

What is Algo Trading?

• The algo trading system (Algorithmic trading or automated trading or black-box trading) 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.
• In essence, it is the process of using computers programmed to trade in order to generate profits at a speed and frequency that is impossible for a human trader.

Current provisions for the use of Algo trading in India

• The facility of algo trading shall be provided by the stock broker after obtaining permission of the stock exchange where the broker servers are located in India and the stock exchange should have appropriate risk controls mechanism.
• All algo orders shall be tagged with a unique identifier provided by the stock exchange.
• The stock exchange should be in a position to shut down the broker’s terminal when needed.

What are the concerns of SEBI?

• Many brokers in India have started providing Application Programming Interface (API) access to their clients which establishes an online connection between a data provider (stock broker) and an end-user (client).
• 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 unregulated or unapproved algos pose a risk to the market and can be misused for systematic market manipulation as well to lure the retail investors by guaranteeing them higher returns. The potential loss in case of failed algo strategy is huge for the retail investors.
• Since these third-party algo providers/vendors are unregulated, there is also no investor grievance redressal mechanism in place.

Proposals of SEBI

Sebi has proposed a regulatory framework for algo trading in its consultation paper.

• All orders emanating from an API should be treated as an algo order and be subject to control by stock broker.
• Stock 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, be certified by Certified Information Systems Auditor (CISA)/ Diploma in Information System Audit (DISA) auditors.
• 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.
• Stock brokers need to have adequate checks in place so that the algo performs in a controlled manner.
• Two factor authentication should be built in every such system which provides access to an investor for any API/algo trade.

What are the Market Concerns regarding the proposals?

• Increase in cost of compliance: Sebi’s paper reinforces the rule that all algos need to be approved by the exchange and has labelled all application programme interfaces (API) as algo. All this may increase the cost of compliance. For e.g., if there is a slight tweak in the algo strategy and a trader wants to change the price level to exit a particular stock, even that will require exchange approval.
• Intellectual property (IP) may be compromised: Third-party tech platforms and traders will need to share their algo and APIs with brokers for approvals. Hence, there is a possibility some brokerages could replicate the algo strategy. This can compromise tech firms’ IP.
• Impact on development of the market: As getting the requisite permission from the stock exchanges is a tedious process, brokers may have to stop using the API system. Thus, putting restrictions may impact development of the market.

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