Regulating algorithmic trading

Providing a segment-specific regulatory landscape for a space that runs on the business model of providing client- and investor-specific services can prove a challenge.

Regulating algorithmic trading
The markets regulator has outlined a framework for the addressing the concerns issues.

By Supriyo Banerjee

The Securities and Exchange Board of India (Sebi) time and again—recently, with its press release 20/2022, has cautioned investors about the volatility of the unregulated platforms that deal with algorithmic trading. Through the press release, Sebi has highlighted certain aspects of the vital need for the protection of the rights of the investors.

There are unregulated platforms that attract retail investors with their lucrative business pitches. Quite often, retail investors can’t invest much time in direct investment in the stock market and thus end up investing their hard-earned money in these unregulated platforms based on algorithmic trading, with the expectation of high returns.

Although the returns in these unregulated platforms are not guaranteed, nevertheless, there has been a massive surge of participation from the retail segment, and Sebi has warned about the fall-out.

With this, there is a belief that the regulation of algorithmic trading is badly needed, though algorithmic trading was allowed by Sebi in 2008.

SEBI, in its consultation paper from December last year, has said, “…any order that is generated using automated execution logic shall be known as Algorithmic Trading.” In simpler terms, algorithmic trading, herein referred to as algo trading, is a type of trading in the market that is done through automated computer programmes that result in a certain specific trading algorithm or command.

Algo trading has grown because of various reasons. Over the years, the

fintech market has played a key role as it has disbursed a large amount of credit. It has grown exponentially, facilitating the rise in the participation of retail investors. Due to this large participation, it has become difficult for humans to carry out the high volume of trade, making algo trading an imperative.

The access to Application Programming Interface (API) for the client or the investor by the brokers is one of the major areas of concern. API provides an online connection between the stockbroker and the client/ investor. Such access enables the investors to use third-party applications that help analyse market data as well as develop client- or investor-specific investment strategies.

But it is quite unfortunate that the algo strategies developed by the third-party applications are not in accordance with the existing provisions as laid out by Sebi. The existing provisions on algo trading, also outlined in Sebi’s December 2021 consultation paper, and the deployment of the algo strategies offered by the third-party apps are found to be contrary to each other. As per the existing provisions, deployment of algo strategies can only be enforced post approval of Sebi, but this is not the case on the ground. This has caused a proliferation of unregulated algos that are mostly used by retail investors.

The markets regulator has outlined a framework for the addressing the concerns issues. In brief, Sebi has suggested that the stock exchanges provide unique algo IDs, and the API should be tagged to the same; this acts as an indication of algo approval by the stock exchange.

Apart from this, certain technological tools need to be developed to enable the stockbrokers to execute checks as necessary, in order to prevent unauthorised changing of the algos. Bringing in a two-factor authentication procedure for systems where the investors have direct access to the algo trading provided the software has also been suggested, to be used by such systems that have received approval from the stock exchange

But the real question that arises is, with the drastic increase in the unregulated platforms and the number of retail investors, how can it be brought under a segment-specific regulation as most platforms run on the business model of providing client- and investor-specific algos.

From the consultation paper, it becomes clear that Sebi is taking steps towards strict regulation of algorithmic trading. Technology should not be a bar for trading, but, at the same time, it definitely needs to be regulated.

In the landscape of unregulated platforms, algo-trading can be considered as volatile. Although many such unregulated platforms are offering huge returns, investors must keep in mind that there is no grievance redressal mechanism that can come to their aid should something go wrong.

It has certainly been quite a while since Sebi’s last proposal for regulating algo trading, but, with compulsions emerging from the fintech market, a more definite regulatory landscape should take shape soon.

The author is a Kolkata-based corporate lawyer.

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