SEBI’s Consultation Paper on ‘Algo-Trading’

Will it effectively lead to a ban on API based Algo Trading.

In 2008, the Securities Exchange Board of India’s (‘SEBI’) introduced the concept of algorithmic trading in Indian markets. In simple words, algorithmic trading is automated execution logic inspired trading based on pre-determined computer strategies fed into the system depending on various market patterns, parameters, or price strategies (“algo-trading”). Access was initially restricted only to institutional investors, however, stock exchanges started leasing co-location servers to brokers and other fintech firms which resulted in a higher retail investor involvement. This resulted in few broader guidelines for algo-trading being put in place in 2012.

Who provides algo-trading services?


Various brokers and fintech platforms like Zerodha, 5Paisa along etc along with several specific algo-trading ventures are involved in this business. It is used by mutual funds, banks and other large financial institutions to enable large volumes of trade as this system removes the need of manual checking and human intervention for execution and also allows a high ability to scale such transactions by automation.


What are SEBI’s concerns?


In the recent years with the huge impetus to fintech companies and their takeover of the market space, third party Application programming Interface (“API”) based algo-trading. In trading, APIs assist in the connection between algorithms and a broker platform to execute transactions. Today, SEBIs extant regulations to govern algo-trading through measures which include monitoring of the broker terminals and approval of all algorithms by the exchange along with having appropriate risk control mechanisms.


However, the third-party applications being used by investors through APIs are unregulated. The broker can identify the trades executed through APIs but they are unable to differentiate between an algo order or a non-algo order. Such algos currently do not need any regulatory approvals. SEBI has said that “This kind of unregulated/unapproved algos pose a risk to the market and can be mis-used for systematic market manipulation as well as to lure the retail investors by guaranteeing them higher returns”. There is also no investor grievance redressal framework for such third party API based algo-trading.


What does SEBI recommend?


Some key proposals, amongst others, made by SEBI through its consultation paper issued on 9th December 2021 (“Paper”) are as below:


  • Treatment of APIs as algo orders which are under the control of the respective stock broker. The APIs carrying out the algo trades should be classified by a unique ID provided by the respective stock exchange providing approval for the said algo.


  • The approval of all algos to be obtained by the stock broker from the stock exchange. Every algo trading strategy has to be approved by the stock exchange and must be certified by a Certified Information Systems Auditor (‘CISA’) or by an individual holding a Diploma in Information System Audit (‘DISA’), which is in line with the existing practices.


  • Stock exchanges and brokers must develop a system which ensures the deployment and usage of only approved APIs and algos. Brokers must ensure that such system prevents the unauthorized alteration and tweaking of approved APIs and algos.


  • Algos developed by an entity must run on the servers of the stock broker wherein the broker exercises control. Stock brokers, on the other hand, must ensure that the algos are deployed and function in a controlled manner. In turn, stock brokers will have to provide grievance redressal mechanisms and be responsible for all investor disputes.


  • The obligations of the stock broker, the third-party algo/API vendor and the trader (end-user client) have to be expressly defined, with the stock broker being responsible for assessing the suitability of the trader before offering the algo facility. Furthermore, the stock broker shall ensure that only those third-party vendors with whom the broker entered into an agreement with, shall use the name of the broker in testimonials within advertisements.


  • Stock brokers will perform specific reports on algorithm checks as a part of the annual audit process and submit the report to the relevant stock exchanges.

A step back in the tech-forward future of Indian Markets?


The key concerns which the market and especially the brokers have is the classification of all API based trading as algo-trading and a requirement of mandatory approval for ‘all’ algorithms even by third party providers. The exchange approval process being tedious and long will result in brokers effectively not providing APIs to third party algo developers and providers. This will effectively lead Indian markets a couple of steps backwards rather than progressing forward to a tech first economy.


There may also be some issues relating to intellectual property whereby all algo-providers will have to reveal their trade secrets to the exchanges through the broker and chances of leakage, re-use etc will be prominent.


What is the best way forward?


In my view, SEBI has itself in its Paper suggested a good way to achieve some sort of middle ground of regulation versus ease of business. SEBI has raised a question as to whether algo developers and providers can come under the definition of ‘investment advisor’ or ‘research analyst’ to be covered by the relevant regulations thereunder. However, investment adviser framework is very heavily regulated and mostly involves client specific advice, while research analysts provide a set of research facts to a broader public sector. In this line, it would make reasonable sense to presently include such third party algo providers to obtain requisite registration under the SEBI (Research Analyst) Regulations, 2014. SEBI can have an effective view of the providers and minor amendments can be made to ensure SEBI’s needs to have sight on the algo traders. While SEBI’s Paper is well-intended and retail investor-driven, it must also factor in the growth of a nascent industry (i.e. fin-tech) that requires a favorable regulatory framework to function and strive to strike a balance between both agendas. The Paper is still open for comments and comments made in this line can be quite effective to achieve a good middle ground between investor protection and ease of business.

 

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