Algo vendors can abuse Sebi directive on compensation structure, warn industry sources

The market regulator recognised that there was a demand from retail traders for algo services. Therefore, to ensure safer participation of retail investors, Sebi issued the directions.

Though the industry and traders hailed the regulator's move, several market participants, such as traders, brokers and even a few algo providers, raised one concern: the compensation to algo vendors by stock brokerages.

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Where the concern lies

Under the new framework, a vendor will need to get their algos registered with the exchanges through the broker.

The broker will act as the principal and the algo vendor as the agent. Only retail traders who want to code their own strategies for their use or for their immediate family's use don't have to register with the exchanges. Even there, the orders per second has to fall below a certain frequency.

According to the directive, the vendor will be compensated with a share of the brokerage's earnings. "Algo providers and brokers may share the subscription charges and brokerage collected from the client," the circular said.

This, according to market sources, can be abused by unscrupulous algo vendors and brokerages. They say a vendor can earn more if the broker earns more in brokerage. Therefore, there are chances that the algo vendors may design strategies that take more trades, to generate more brokerage and thus to earn a higher commission.

"There is already an arrangement in place where algo vendors are offered 30-60 percent of brokerage generated," said an insider.

Also, it pays better if an algo provider has an associate who is an authorised person (AP) of the broker, added this source. "If the vendor or vendor's associate (like a family member registered as the broker's AP) is bringing the client, the brokerage share would be 60 percent. If the broker is bringing the client, the share would be closer to 30-40 percent," he said.

Sebi's stand

In response to Moneycontrol's queries, Sebi said that the broker can decide how to compensate the algo provider and that the broker is required to make adequate disclosures to the client to address any conflict of interest.

As per the circular, "there is no restriction on the broker regarding brokerage / subscription fee sharing arrangement and he may change to fixed or monthly/periodical fee as agreed mutually with the algo providers. The requirement of disclosures is intended to address the concern of conflict of interest. Accordingly, the broker is required to ensure that complete disclosures of all charges are made to the client, thereby ensuring transparency."

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Sebi's circular on algo norms also clearly states that "prominent and complete disclosures of all the charges shall be made to the client. The broker shall also ensure that such arrangements do not result in any conflict of interest".

Industry insiders said that this may not be enough of a safeguard as retail clients may lack the sophistication to understand what the disclosures mean. Also, one source added that the brokerage can claim that they were not sure that the strategy was designed with bad intent.

On the possibility of an AP registering as an algo provider, the regulator said that it has not come across such instances. "An AP, by role, is the agent of the broker, servicing investors. We have not come across a situation where an AP is also empaneled with the stock exchanges as an algo provider," Sebi said.