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Algo trading: Why SEBI wants to regulate segment

Algo trading: Why SEBI wants to regulate segment

Investors want to know how algo trading can be safe and how the authority can ensure the market isn't manipulated for the value of their shares

As the Securities and Exchange Board of India (Sebi) is close to announcing a regulatory framework for algo trading by retail investors, the uninitiated are asking what it is and how such trading can be safe and how the authority ensures that the market cannot be manipulated for its value.

In December 2021, Sebi had published a consultation paper that said it was considering regulations in algo trading. The regulator sought feedback on retail investors using algo-trading tools such as Application Programming Interface (API) access.

Algo trading

In information technology lingo, a predefined set of commands to dictate how and in what order things appear on a platform is called a program or an algorithm. From this word comes “algo”, obviously an abbreviation. It sets the criteria for buying and selling stocks and other assets such as futures and options (F&O), commodities and currency derivatives.

An act of trading stocks using a program or algorithm is algo trading, which could dictate, say, buying 100 TCS shares every the depreciates 5% against the dollar. The trades take place faster and manual monitoring is done away with. This is like employing a broker to buy and/or sell shares based on specific instructions.

In algo trading, a computer instead of a human being analyses the data and so the scope for error is low. Such trades may see drastic price changes as commands are executed within seconds.

Algo trading is already in use to manage mutual funds, hedge funds, insurance companies, banks and other institutions to execute a large number of high-volume trades that are otherwise impossible for human beings to carry out.

In the past 10 years, the rise of fintech firms — Zerodha, 5Paisa, Alice Blue Algo Trading Platform, Fox Trader Algo Trading Platform and Mastertrust Algo Trading Platform, for example — has led to an increase in retail participation..

A Sebi regulation could impact such low-cost, fintech-based brokerages that have been adding millions of clients.

Why Sebi is worried

The National Institute of Financial Management says that algo trading has a 50% of the Indian financial market (2018). In the US, about 80% of all trading is algo trading. The issue for the authority is that exchanges submitted by retail investors using APIs cannot be identified as algo or non-algo — by either the broker or the exchange. So, as of now, the regulator permits exchanges only by brokers.

The aforementioned paper of Sebi said these unregulated or unapproved algo trading cases posed a risk to the market. It said that they could be misused for systematic market manipulation and to lure retail investors by guaranteeing them higher returns.

Solution proposed by Sebi

Sebi wants all orders from an API to be treated as algo orders and be subjected to control by stock brokers. APIs must be tagged with a unique algo ID provided by the stock exchange granting approval for the algo.

The regulator wants technological tools to ensure appropriate checks “to prevent unauthorised altering or tweaking of algos”. Sebi wants to offer brokers either in-house algo strategies developed by an approved vendor or outsource the services of third-party vendors.

Recent developments

The National Stock Exchange (NSE) is exploring an “unsupervised machine learning model” to plug anomalies in algorithmic orders. In its annual report for 2021-22, the exchange said that it had developed well-curated market surveillance mechanisms backed by a robust technology architecture over the years.

NSE’s surveillance systems identify malpractices and ensure timely management of identified breaches. In order to upgrade and tighten its surveillance, the exchange rolled out measures in 2021-22 like the deployment of alerts to detect market abuses in equity stock options, OTM (over-the market) contracts, capture multi-leg reversal cases as well as abuses wherein option contracts are traded at away prices without a change in the underlying assets. “Exchange is exploring with an ‘Unsupervised Machine Learning model’ to detect anomalies in algo orders,” the annual report noted.

Algo trading in India

Algo trading is not really new in India’s financial markets. It was introduced and allowed by Sebi in 2008; initially, it started with Direct Market Access and was restricted to institutional investors. After stock exchanges started leasing co-location servers to brokers and fintech firms, retail participation started growing.

In 2012, the regulator put in place broad guidelines for algo trading in the Indian securities market.

“Any order that is generated using automated execution logic shall be known as algorithmic trading,” it had said. It also specified minimum “order-level risk controls” that would include price checks, quality limit checks, a system to identify dysfunctional algorithms, and the requirement of a monthly report on algo trading by stock exchanges.

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