Regulating Algorithmic Trading
Headstrong attempt by SEBI to regulate algo trading
The Securities and Exchange Board of India(SEBI), released a consultation paper on December 9 that outlined the possibility of a regulatory framework for algorithmic trading by retail investors. Before we jump on to understand what the paper said and what it meant for the average retail investor, let us take a step to understand algorithmic trading.
What is Algorithmic Trading?
Let us go by the bookish definition for starters.
Algo trading is also known as Algorithmic trading, is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume.
If this did not make sense, then let us take try to connect the dots and understand better. Say you want to buy an ITC stock at ₹280 (yes, it is hypothetical). You place a GTT(Good Till Trigger) that will automatically buy for you as the share touches that price. But what if you wish to buy the same stock as the Nifty Index go down? You would say, probably keep tracking until it goes down. Algo trading solves this for you with automatically executing orders based on one's pre-defined logic using programming languages.
How this works?
The program, or algo can be designed to keep a watch on the live market data and generate alerts on buy or sell, or even automate the entire buying or selling.
There are two ways in which this can be materialised:
Usage of third party automation tools that plug into these platforms to place orders automatically on a broker’s trading application. These automation tools are also called macros and can be created on Amibroker, Metastock, Python programs or Excel etc.
Using APIs (Application Programming Interface) provided by the stock broker. This does not involve any reverse-engineering unlike previous method and you're given access to programmatically pull all the data needed for one's order.
For the scope of this article, I am skipping the first method and will double down more on the API method of algo trading.
APIs in Algo Trading
Before we jump on to deep dive, the question is what is an API?
"API stands for Application Programming Interface, which is a software intermediary that allows two applications to talk to each other."
In simple terms, all that happens on any application over internet is facilitated via an API, including data transfer, actions, information retrieval etc. Hence, these stock brokers provide APIs so that one can, using their own program, place orders on the broker platform without using the broker app. It will enable to talk to the stock broker platform without having to use the app.
To understand better, a video which explains API in simple terms.
The Indian Market
Stock broker platforms like Zerodha and other online platforms provide these APIs to allow users programmatic access via API to their own accounts. However this market is very small owing to the programmatic skills this process demands. As stated by Zerodha, "less than 0.05% of our customers use APIs, and an even smaller fraction use them to place orders."
This has given way to other no-code platforms to mushroom and provide users the ability to make algorithms to trade on the markets without having to code. They even provide their own off-the-shelf algos with backtested results claiming X% profit over the last couple of years. The concern here is, most of these platforms are unregulated and mislead people into taking frantic decisions.
Highlights of the Consultation Paper
This Consultation Paper rolled out by SEBI on regulatory framework for algorithmic trading stirred a lot of opinions on the matter. This regulation came as a result of SEBI's worries over algo traders, as stated in Para 4.9 of the consultation paper, stating the risk that unregulated algorithms pose to the market, which can be used for systematic market manipulation and luring retail investors with the promise of high returns.
The Consultation paper states that if a majority of these algorithms fail in the market which are being developed by the unregulated third-party vendors, the retail investors can face significant losses. In this case, there is no mechanism for resolving investors grievances which can cause major concerns for the market regulator.
Currently, exchanges approve the algorithms submitted by the broker, but as stated (Para 4.5), neither the stock exchanges nor the stock brokers can determine whether the trade emanating from the API link is an algo or a non-algo trade. To address this issue, SEBI suggested (Para 6.1) that all orders originating from an API be treated as algo orders and must be subject to stock broker control, and the APIs used to conduct out algo trading should be labelled with the unique algo ID issued by the stock exchange giving approval for the algo.
Before delving into the impacts of the regulations, we'll take a look at some other SEBI-proposed provisions-
Brokers shall use appropriate technological means to guarantee that adequate safeguards are in place to prevent illegal changes or tweaking of algos.
Stock brokers must have enough checks in place to ensure that the algorithm operates in a controlled manner. All algos produced by any business must run on the broker's servers, where the broker controls customer orders, order confirmations, and margin information, among other things.
Brokers can either build in-house algo strategies or outsource the services of a third-party algo provider/vendor.
Stock brokers should be held accountable for all algos originating from their APIs, as well as the resolution of any investor concerns.
The obligations of the stock broker, the investor, and the third-party algo provider must be defined separately.
SEBI also proposed that two factor authentication be implemented into every system that gives an investor access to any API/algo trading.
Interpretation for intermediaries- approach of US
It is indeed true, that regulating the nascent algo market is the need of the hour especially in the backdrop of rising cases of retail clients losing money based on false promises made by third- party algo vendors, but at what cost? It seems that SEBI, has put its gun on the shoulder of the stock brokers. The Paper clearly outlines the hefty liability and compliance on the part of the brokers for algo trading. Since the securities market is already highly regulated, and intermediaries must comply with a plethora of statutes, these regulations will only add to their burden.
If algo trading poses such a high risk of market manipulation, I believe the market regulator, rather than the brokers, should bear responsibility for such trading. The same was also highlighted by Nithin Kamath, co-founder, Zerodha, raising concerns over SEBI proposals. He added that getting exchange’s approval for any algo would be “extremely tedious and complex process”. In addition, he and Vikas Singhania, CEO of TradeSmart, made it clear that these proposals would make it difficult for brokers to offer APIs.
The other thing that needs to be highlighted should be the scope of algo trading. How can SEBI propose that all trades originating from APIs be classified as algo trades? I believe the solution is in the US securities legislation. A proper scope of algo trading has been defined by the National Association of Securities Dealers Rules (NASD Rules), and according to it (NASD Rule 1032(f)), all persons associated with the algo designs must be registered as Securities Traders. Here, the U.S. Securities and Exchange Commission (SEC), unlike SEBI, has made sure that the algo traders are regulated right from the start and thus, taking the entire burden of its regulation.
The nature of work these third party algo vendors perform is very much incidental to the work of an Investment Advisor or an Analyst or a Portfolio Manager. In this case, SEBI can bring all of these third-party algo vendors under the purview of the 2013 Regulations for Investment Advisors and Financial Planners. As a result, compliance and regulatory work can be easily shared among SEBI, stock exchanges, and stock brokers.
What does it mean for the future?
This consultation paper, immediately created a lot of noise and as mentioned previously the front-runners in this business likes of Nithin Kamath came foreword to express concern over such a definition. The task of getting algos validated from the broker itself is a challenging one since the broker platform can never make sure which of the algorithms actually ran from the customer's end using the API. This will ultimately lead the brokers to stop providing this API since they can never comply to the clauses as mentioned in the paper.
As pointed out by Nithin Kamath in the above discussion, this means, moving two steps back in a digital era. What is needed is that SEBI should take a constructive view on the entire algo trading fiasco by carefully determining and sharing responsibilities among the other market participants for a better market regulation.