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Explained: Why is SEBI concerned about rise in algo trading by retail investors

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SEBI has released a consultation paper seeking suggestions on algorithmic trading being done by retail investors. Here are some of the terms, concepts mentioned in the paper and SEBI’s objective.

Explained: Why is SEBI concerned about rise in algo trading by retail investors
Capital and commodities markets regulator SEBI has released a consultation paper seeking suggestions on algorithmic trading being done by retail investors including the use of API access and automation of trades using the same.
In this article, we try to explain some of the terms, concepts mentioned in the paper and SEBI’s objective.
First up, what is algo trading?
Algo trading means the use of a defined set of instructions in the form of algorithms to generate trading signals and placing orders with the broker.
Give me an example?
Say I want to buy shares of Tata Steel if it rises 2 percent over its previous close and if trading volumes on that day is higher than the average volume of the last 10 days.
I can simply put this order through a broker’s website or app, and wait for the order to be executed. However, I will only be able to specify the price, not the volume.
Another way is to monitor live stock prices and manually place the order when the order is bet.
A third way is to have a software with an algorithm that will place the order only when both conditions are met. Whenever the algo generates a signal, an order automatically gets fired from the investor’s account with no human involvement from either the broker or the investor.
What are the current rules on algo trading by retail investors?
Brokers need the approval of exchanges to offer algo trading. They need to inform exchanges of any changes to the algos.
All algo orders have to be routed through broker servers located in India. Also, all algo orders have to be tagged with a unique identifier provided by the stock exchange in order to establish an audit trail. This allows the exchange to know if an order is an algorithmic one or non-algorithmic.
Why is SEBI concerned about the rise in algo trading by retail investors?
That is because many brokers in India have started providing Application Programming Interface (API) access to their clients.
Wait a minute, what exactly is this API stuff?
An API or application programming interface is a set of programming codes that analyses data and sends instructions between one software platform and another. In this case, it will be between the broker’s software and the software being used by the client
OK, so how do brokers’ clients use this?
Retail traders typically look for opportunities by screening stocks based on certain parameters. Earlier, they had to identify such stocks on a separate application and then place trades with their broker. In other words, the trader’s screening software and the broker’s software could not speak to each other. But with brokers providing APIs, traders can connect their screening software with the broker’s API offering access to real-time prices. The screening software will identify opportunities based on the live prices, and automatically place orders.
Some traders create their own algos or get them from some third party.
Where does SEBI come into the picture?
The regulator has observed that while the services of these third-party applications are increasingly used by retail investors), such algos are being deployed without taking requisite approvals from the exchanges.
For algos offered by brokers, the exchange can identify if it is an algo trade or a non-algo trade. For the algos deployed by retail investors using own or third-party applications, neither exchanges nor brokers are able to identify if the particular trade emanating from the API link is an algo or a non-algo trade.
What is the downside of this?
SEBI feels unregulated algos pose a risk to the market and can be misused for systematic market manipulation. Also, the firms selling such algos could lure retail investors by guaranteeing them higher returns. The potential loss in case of a failed algo strategy could be huge, the regulator says. Since these third-party algo providers are unregulated, there is also no investor grievance redressal mechanism either.
What is SEBI proposing?
All orders emanating from an API should be treated as an algo order and be subject to control by stock broker. The APIs to carry out algo trading should be tagged with the unique algo ID provided by the stock exchanges.
Brokers will need to take the approval of all algos from the stock exchanges. Each algo strategy, whether used by broker or client, has to be approved by the exchanges.
Brokers shall ensure that appropriate checks are in place so as to allow only exchange approved algos.
Brokers will be responsible for assessing the suitability of investors prior to offering algo facility. No recognition shall be given by the exchange to the third party algo provider/vendor creating the algo.
The stock broker will be responsible for all algos emanating from its APIs and redressal of any investor disputes.
Are these measures feasible? What are market participants saying?
Zerodha co-founder Nithin Kamath feels that the suggestions if implemented will cause brokers to stop offering APIs. That is because getting exchange approvals for any algo used by any customer using APIs, and also validating that the order being placed is from that strategy itself, is an extremely tedious and complex process.
“Disallowing APIs will also not solve the problem of unregulated algo trading platforms. They will just shift from using broker APIs to third party automation tools which aren't in the control of the brokers. The only way to solve this problem is by regulating these algo platforms,” he tweeted.
What are the global rules on algo trading?
In April 2016, the U.S. Securities and Exchange Commission (SEC) approved a rule proposed by the Financial Industry Regulatory Authority (FINRA) that would require algorithmic trading developers to register as securities traders. The move was primarily aimed at reducing market manipulation.
In the UK, any market participant must notify the regulator Financial Conduct Authority if it is engaging in algorithmic trading.  A firm must provide the following, at the FCA’s request, within 14 days from receipt of the request: (1) a description of the nature of its algorithmic trading strategies; (2) details of the trading parameters or limits to which the firm’s system is subject; and (3) any further information about the firm’s algorithmic trading and systems used for that trading.
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