Explained: What is algo trading and why SEBI wants to regulate retail investor activity in this segment

Almost everything in the digital world is based on algorithms. The ad that popped up while scrolling through Facebook? Algo. The app recommendation? Algo.

Algorithms leverage user data, behaviour and usage patterns, and take in pre-specified instructions to achieve certain goals. In trading, it uses a predefined set of commands to dictate the exact criteria for buying and selling stocks or other asset classes like futures and options, commodities, and currency derivatives.

A simple example of an algo trade could be: Buy 100 Infosys shares every time the rupee depreciates 5 percent against the US dollar.

Users can feed in any set of instructions based on time, volume, price, patterns, complex strategies, and let the algorithm do the rest.

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It’s like asking a broker to buy or sell shares at a specific time or at a certain price, except that algorithmic trading is faster – computers analyse a lot more data than a human can in a given time and have less scope for error. Also, significant price changes can be avoided because orders are executed within seconds.

Thus, investors can execute more trades faster since less time is required to manually monitor, select, buy, sell, initiate order placements and so on.

When did algo trading start in India?

Algo trading isn’t really new in India’s financial markets. It was introduced and allowed by SEBI in 2008, and initially, it started with Direct Market Access and was restricted to institutional investors. After the stock exchanges started leasing co-location servers to brokers and fintech firms, retail participation started growing.

In 2012, the regulator put in place broad guidelines for algo trading in the Indian securities market.

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“Any order that is generated using automated execution logic shall be known as algorithmic trading,” it had said. It also specified minimum “order-level risk controls” that would include price checks, quality limit checks, a system to identify dysfunctional algos, and a requirement of a monthly report on algo trading by stock exchanges.

Who engages in algo trading? Which platforms offer these services?

Generally, algo trading is used by mutual funds, hedge funds, insurance companies, banks, and other institutions to execute a large number of high-volume trades that are otherwise impossible for humans to undertake.

Over the past decade, the rise of fintech firms has led to an increase in retail participation. Some of these platforms are Zerodha, 5Paisa, Alice Blue Algo Trading Platform, Fox Trader Algo Trading Platform, Mastertrust Algo Trading Platform.

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Any regulation by SEBI could impact such low-cost, fintech-based brokerages that have been adding millions of clients.

What are SEBI’s concerns?

Algo trading’s share in the Indian financial market had stabilised at about 50 percent, according to a report by the National Institute of Financial Management in 2018. It makes up for about 80 percent of all trades in the US.

Currently, exchanges approve algos submitted by brokers. However, for algos deployed by retail investors using APIs, neither the exchanges nor the brokers can identify if a trade emanating from the API link is an algo or a non-algo trade.

“This kind of unregulated/unapproved algos pose a risk to the market and can be misused for systematic market manipulation as well as to lure the retail investors by guaranteeing them higher returns,” SEBI said in its consultation paper.

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It also warned that potential losses in case of a failed algo strategy could be huge for retail investors since third-party algo providers are unregulated and there is no investor grievance redressal mechanism in place.

SEBI suggests that all orders from an API should be treated as algo orders and be subject to control by stock brokers. The APIs must be tagged with a unique algo ID provided by the stock exchange granting approval for the algo, the regulator said.

It said there should be technological tools to ensure appropriate checks “to prevent unauthorised altering or tweaking of algos” and suggested that brokers could either provide in-house algo strategies developed by an approved vendor or outsource the services of third-party vendors.

SEBI has sought comments from the public on the proposals till January 15.