The Securities and Exchange Board of India (Sebi) has proposed a fresh regulatory framework for algorithmic trading or algo trading by retail investors. According to the consultation paper released by Sebi, the proposal is aimed at preventing market manipulations.

Sebi said the objective of the consultation paper is to seek comments/views from various stakeholders, including market intermediaries and the public on algorithmic trading being done by retail investors.

WHAT IS ALGO TRADING?

Algorithm-based trading includes the use of API access and automation of trades using the same. In other words, it is a trade that is generated using automated execution logic.

In an algorithm-based trade setup, the system automatically monitors live stock prices and initiates an order to (book/sell) upon meeting a certain pre-determined request. This system eases the burden on traders as they are not required to monitor stock prices in real time and place manual orders.

EXISITNG NORMS FOR ALGO-BASED TRADE

Citing existing provisions, Sebi said in its consultation paper that the use of an algorithm for trading shall be provided by the stock broker after obtaining permission from the stock exchange.

It added that all algo-based trade orders shall necessarily be routed through broker servers located in India and the stock exchange should have an appropriate risk control mechanism to address risks due to such trade.

Furthermore, all algo trade orders shall be tagged with a unique identifier provided by the stock exchange in order to audit trail and the stock broker shall seek approval from the exchange for any modification or change to the approved algos or systems used for algos.

Sebi also said that the stock exchange shall have arrangements, procedures and system capability to manage the load on their systems in such a manner so as to achieve consistent response time for all stock brokers.

Simply put, stock exchanges currently provide approval for algo-based trades submitted by brokers.

WHAT HAS SEBI PROPOSED?

As mentioned earlier, Sebi has proposed a framework for algo-based trade by retail investors done using API access and automatic initiation of trades. In the case of algorithms deployed by retail investors using APIs, it is hard to identify details of an algo-based trade.

“This kind of unregulated/unapproved algos pose a risk to the market and can be misused for systematic market manipulation as well as to lure the retail investors by guaranteeing them higher returns. The potential loss in case of failed algo strategy is huge for retail investor. Since these third-party algo providers/vendors are unregulated, there is also no investor grievance redressal mechanism in place,” the Sebi consultation paper said.

Therefore, Sebi has suggested that all orders “emanating from an API should be treated as an algo order and be subject to control by stock brokers 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”.

The market regulator also said that a 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, each algo strategy has to be certified by Certified Information Systems Auditor (CISA)/ Diploma in Information System Audit (DISA) auditors,” it added.

Sebi proposes stock brokers to deploy suitable technological tools to ensure that appropriate checks are in place to prevent “unauthorised altering/tweaking of algos”.

“All algos developed by any entity have to run on the servers of a broker wherein the broker has control of client orders, order confirmations, margin information etc. Stock brokers need to have adequate checks in place so that the algo performs in a controlled manner,” it added.

The market regulator has also suggested that 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.

It added that a stock broker is responsible for all algos emanating from its APIs and redressal of any investor disputes.

“Obligations of stock broker, investor and third party algo provider/vendor need to be separately defined. Stock broker is responsible for assessing suitability of investor prior to offering algo facility. No recognition shall be given by the exchange to the third party algo provider/vendor creating the algo,” Sebi said.

Sebi said that two factor authentication should be built in every such system which provides access to an investor for any API/algo trade.

The market regulator has sought comments from the public till January 15 on its proposal on algo trade.