Retail algos are prohibited by SEBI
India’s securities market has changed significantly over the past ten years. The “Securities Exchange Board of India” (SEBI), which is composed of numerous regulations and guidelines, deals with the buying and selling of securities, including shares, mutual funds, etc., and the depositories of stock exchanges (SEBI Act, 1992). SEBI’s primary goals are protecting investors’ interests and developing the securities market. Investment firms and advisors to institutional investments have to reconsider their trading strategies in light of the ongoing development of technology and innovations aimed at lowering costs in the securities market. A new sector of the securities market has thus been created as a result of improved technologies and algorithmic trading.
Trading algorithms in India
2008 saw the introduction of algo trading by SEBI and the beginning of “Direct Market Access” (DMA), which allowed brokers to introduce their infrastructure with the exception of retail consumers.
“Smart Order Routing” (SOR), which SEBI adopted in 2010, allowed investors to place trading orders immediately without having to second-guess which exchange was offering the best securities price.
The proportion of BSE’s (Bombay Stock Exchange formerly) equity turnover that was reliant on algorithmic trading climbed to over 50% in 2011. Co-location was soon introduced, giving members access to their own servers inside exchange facilities.
Algo trading process
When an algorithm is offered by a broker (to purchase or sell), the algorithm needs SEBI’s approval. It applies if the broker employs such an algorithm for his personal trading (prop trading) or when he makes an offer to investors. When the broker makes an offer, the software runs on the broker’s systems. When the algorithm generates a signal, an order is automatically executed on the investor’s account without the need for a human to be present.
An “Application Programming Interface” (API), which establishes internet links between a stockbroker and his client, is now being made available by Indian brokers to their customers. A software middleman called an “API” allows two apps to communicate with one another. You use an API when you send a message using Facebook, WhatsApp, or your mobile device to check for messages. For instance, when we log in to Facebook, Google, Twitter, and other services, API is used to launch those applications and check whether the user is signed in or not. If not, a pop-up asking the user if they really want to log in to their profile is presented when they first log in. The programme receives identity information from the API when the user confirms their login, and as a result, it is able to identify the user.
Many traders contact broker APIs through third-party applications to execute trades. The trading API allows traders to create their own computer programmes for trading. These APIs assist traders in developing custom trading programmes.
Currently, brokers propose algorithms that are accepted by the exchanges. Retail investors cannot tell whether a trade coming via an API link is an algo trade or not, even though they use APIs, exchanges, and brokers to deploy algos. These unregulated/unapproved algos “represent a risk to the market and can be utilized for systematic market manipulation as well as to entice the ordinary investors by offering them bigger returns,” according to SEBI. If the third-party algo vendors or providers are not subject to regulation and the retail investors have no way to file a complaint, there could be significant losses for them.
The SEBI’s proposal
The orders that originate from an API are referred to as algo orders. These algorithmic orders will be in the stockbroker’s hands. A distinct Algo ID will be given to the API used by this Stock Exchange to conduct algo trading once the stock exchange has given its clearance. The stock exchange must approve each algo strategy before brokers or clients can use it, and these algo strategies must have an auditor’s certification as an information systems auditor or a diploma in information system audit. In order to prevent unauthorized modification or tweaking of such algos, brokers must use the proper technological tools to assure the deployment of the necessary checks.
All of the algos must be executed on the broker’s server, and the broker is in charge of all margin data, order confirmations for clients, etc. Stockbrokers must supply internal algo strategies that are created in collaboration with approved vendors. However, stockbrokers may also contract with external algo vendors for such services in a formal arrangement. All of the algos that come through the stockbrokers’ APIs must be under their control, and they are also in charge of handling investor disputes. Investor obligations, obligations of third-party algo providers, and obligations of stockbrokers must all be defined separately. Every system needs two-factor authentication so that investors can access any algo trade. The permission of the exchange is necessary for the programme that generates strategies. The stockbrokers must disclose algorithm checks in the yearly system audit report, which must also be filed to the Exchange. The report must follow a specific structure.
Concerns with the concept
If every API-based trade is categorized as an algorithmic trade, that would be unjust. One entire market exists just for API. As a result, brokers and knowledgeable players who are linked up for reasons other than algo trading will be slower to connect.
Brokers now have a significant administrative burden as a result of the proposed framework because they must make sure that individuals employing third-party suppliers’ algos have received stock exchange approval. As investment strategies change, the expense of the clearance process will now need to be followed every time an algo strategy is modified. This weight falls on the stock exchange, traders, brokers, and developers.
Result for retail investors
Insofar as retail investors’ interests are concerned, the plan is a step in the right direction. The rule guarantees both the protection of retail investors and the suitability of those investments. The rule will give retail investors who are interested in algo trading more confidence. There won’t be any price manipulation if there are restrictions in place, and investors may avoid suffering significant losses as a result.
The decision may have two effects: first, it might raise compliance costs for brokerages similar to Robinhood, which are gaining customers due to their low-cost trading options based on computer-generated trading algorithms. In addition, it will enable conventional brokerages to provide algorithmic services to their retail clients rather than just hedge funds and other institutions, which are currently covered by rules. Despite having the best of intentions, SEBI’s decision to classify all API-based trades as algorithms may be detrimental to the ecosystem as a whole and inhibit innovation.
A threat to the Indian securities market is posed by third-party trading apps that are not registered with or regulated by exchanges. These apps break the rules by misleading retail investors into believing they will receive larger returns. Such apps offer to give small-scale investors four-digit returns on double-digit investments. These stock market apps are the devils that sap investors’ confidence in the financial system.
Due to their unregulated nature, these trading applications draw a large number of traders and investors. As a result, mistakes made by these traders and investors in algo trading will result in multiple incorrect trades being executed simultaneously. These unregulated algos hold a large number of investors, making it possible for them to manipulate the market in various ways. Therefore, placing limits will help the securities market expand and thrive.
With input from key market players, SEBI should develop a structure that simultaneously protects investors’ interests and their integrity without impeding technological advancement. If it happens automated trading systems will be a risk-free place and algo trading in India expands even more.