SEBI has issued a consultation paper on Algorithmic Trading by Retail Investors dated 09th December, 2021, on the regulatory framework for algo trading by retail investors to ensure that no unregulated activities are carried on and that there are no market manipulations.
What is Algo Trading?
It is referred to any order that is generated using automated execution logic where a defined set of instructions are given to generate trade signals and placing orders. These algo trading system automatically monitors the live stock prices and initiate an order when the given criteria are met. This frees the trader from monitoring live stock prices and initiating manual order placement.
For Example- A retail investor who doesn’t have the entire day to monitor the market wants to buy a share, say Tata Motor only if the following instructions are met. The instruction is as below:
· If the current price crosses its 20 days moving average, and
· If the volume on the day is greater than the average of the last 20 days, and
· If is the last trading hour of the day.
Now, this is where algos are helpful, it will generate a signal, an order will be automatically be executed when all the above sets of instructions are met without any human involvement.
What has led to the increase in Algo trades?
It frees the trader from having to monitor live stock prices and initiate manual order placement. Retail traders do not trade full-time because they work at jobs/businesses and participate in the markets to earn additional income or to grow their capital.
What are the market concerns that can be foreseen?
· It would be a tedious and difficult process to explain the complexity involved in framing the algos and getting approval from Stock exchanges.
· Often brokers outsource their algo services to third-party vendors. In accordance with the consultation paper, now the brokers shall be liable for such third-party vendors as well. Further, where any algo strategy is altered even that will require stock exchange approval. All this may increase the cost of compliance.
· Third-party tech platforms and traders will need to share their algo and APIs with brokers for approvals. This might compromise tech firms’ IP as there could be a possibility of replication of the algo strategy.
What are SEBI’s broader concern?
· SEBI has observed that though the brokers are able to identify that the order is placed from an API, they are unable to differentiate between an Algo trade and non-Algo trade as most of the Algos which has are being used are without any formal approvals from the Stock exchange. This poses a huge financial risk for the retail investor who can easily fall into trap of the attractive return offered. It can also lead to market manipulations.
· SEBI has also observed that these unregistered algo platforms provides services which are in nature of investment advisory services as they advise on strategies to the investors based on the research and analysis done by them. However, these algo platforms are not registered with SEBI as Investment Adviser, which is a breach of regulatory norms.
SEBI in order to resolve such concerns and protect the rights of the retail investors have proposed the following framework:
· All orders emanating from an API should be treated as an algo order and be subject to control by the 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.
· Stock broker needs to take the approval of all algos from the Exchange. Each Algo strategy, whether used by broker or trader, has to be approved by Exchange.
· Stock Exchanges have to develop a system to ensure that only those algos which are approved by the Exchange and having a unique algo ID provided by the Exchange are being deployed. Brokers shall also deploy suitable technological tools to ensure that appropriate checks are in place to prevent unauthorized altering/tweaking of algos.
· All algos developed by any entity have to run on the servers of the broker wherein the broker has control of orders, order confirmations, margin information, etc. Stock brokers need to have adequate checks in place so that the algo performs in a controlled manner.
· Stock brokers can either provide in-house algo strategies developed by an approved vendor or outsource the services of a 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.
· Stock broker is responsible for all algos emanating from its APIs and redressal of any investor disputes.
· Brokers will be responsible for assessing the suitability of the investors before offering an algo facility. No recognition shall be given by the exchange to the third party algo provider/vendor creating the algo.
· Stock brokers shall ensure that only those third party algo providers/vendors, with whom the broker had entered into an agreement, shall use the name of the broker as part of their testimonial, provided Exchange prescribed advertisement guidelines are met.
· Two-factor authentication should be built in every such system that provides access to an investor for any API/Algo trade. The software to be used to create the strategies should be approved by the Exchange.
· Stock brokers shall include a specific report on algorithm checks implemented by them as a part of the annual system audit report submitted to the Exchanges and the format for the same shall be prescribed by the Exchanges.
Even though SEBI’s concerns are genuine and the intention to bring the algo trading within the ambit of the SEBI regulation, there seems to be a challenge to ensure the compliances of the proposed regulation. We need to now wait and see how SEBI address the concerns of the market in its regulation.
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