SEBI

SEBI’s Proposal on Regulation of Algo based trading

As more and more people are getting exposure of stock market and the more people have started investing in the same, different methods of trading have been evolving. One such method of trading is algo based trading or algorithm based trading. However, few inconsistencies have been observed in functioning of algo based trading by Securities and Exchange Board of India (SEBI). With a view to introduce a regulatory framework for the algo based trading used by the retail investors and preventing a situation of systematic market manipulation, SEBI has released a consultation paper seeking comments and views from the stakeholders, market intermediaries and the public.   

What is an algorithm?

An algorithm is a set of instructions to solve problem or to execute a task in a particular set of situation.

What is Algo based trading?

Algo trading or algorithm based trading is the process where predetermined trade instructions (buying/selling) are given by the user to the software to automatically execute those instructions within seconds when the situation conceived by the user arises in the market.  For example an instruction has been given to the software to purchase 1000 shares of a certain company when the market goes 100 points down. So whenever the market goes down by 100 points, the software automatically makes the trade to buy that stock without the instructor to monitor the market and manually make the trade when such market situation actually arises. The software automatically makes the trade on behalf of the user.

So, algorithm based trading allows the user to execute multiple trade instructions related to multiple securities according to the desired market situation of the user without the user to constantly monitor market at every moment and manually make the trade.

Benefits of Algo based trading

Given the concerns that the SEBI has with regards to the scope of malpractices associated with the third party algo base trading are well founded, the benefits associated with the algo based trading system cannot be ignored. Following are the benefits that are associated with algo based trading:

1. Undertaking huge volumes of trade: The Algo based trading allows the investor to undertake huge volumes of trade which are otherwise impossible for an individual investor to undertake. Algo based trading removes this advantage that is available with the institutional investors only.
2. Removes the need of manual monitoring of market and making manual trades: The algo based trading allows the investor to do away with the need to physically monitor the market all the time and wait for the right time to make the trade. The investor can now give the directions beforehand and the trade shall be placed at the right time without physical presence of the investor.
3. Timely execution of trades without possibility of human errors: One of the best features of algo based trading is that it allows the investor to make trades at the desired timings without worrying about the human errors.
4. Takes care of multiple market conditions: The investor here has the opportunity to trade simultaneously in several markets which was restricted earlier due to the limitations of manual trading.

SEBI’s concerns regarding Regulation of Algo based trading

Currently, the stock exchanges only recognise and approve the algorithms of the stock brokers that the stock brokers have submitted to the exchanges. The stock exchanges cannot decipher whether the trade linked with the API emanates from an algo based or non-algo based trading.

The SEBI is concerned with the following drawbacks that are associated with the third party algorithm based trading:

Systematic Market Manipulation

SEBI has apprehensions that the introduction of unregulated API routed algo trading can possibly result in systematic market manipulation.

Non-regularized

A surge has been observed in recent times in the retail investors making their investments with the help of third party algo providers. Keeping in mind that the activities of the third party algo providers are not regulated by the SEBI, these retail investors position will be jeopardized in case the strategies adopted by them are found to be false. The retail investors will be at the receiving end and entail huge losses with no place to get redressal for their complaints.

No system for grievance redressal

Given the fact that market is unregulated with respect to third party algo providers, there is no place for investor grievance redressal mechanism. In case any investor experiences any fraud or unfair trade practice, there is no place for the investor to get redressal due to the fact that no government authority is there to supervise, regulate and penalise the acts of a third part algo provider.

Suggestions by SEBI

In order to counter the above mentioned drawbacks related to the third party algorithm based trading method, SEBI suggests that every trade linked with API should be treated as an algo based trading order and the stock exchanges shall have a control over such trades.

SEBI^[1] also suggests earmarking every API with a unique algo identity number which will be provided by the concerned stock exchange who shall grant approval for the algorithm. This will help the stock exchange in tracking the transactions as algo or non algo based trading.

Conclusion

It must be understood that the algo based trading is here to stay. It gives the investor an opportunity to use the experience gained in the market and make trades without worrying about the limitations attached with the manual trading where the investor has to monitor the market all the time and manually make the trade. Further, it dispenses with the constant presence of the investor monitoring the market and the right time to make the trade. However, the drawbacks that have come to the fore regarding the unregulated third party API linked algorithm based trading definitely requires the regulation from SEBI to protect the interest of the retail investors.

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