Why Are Brokers Opposing SEBI’s Regulations In Algo Trading?

Recently, the Securities and Exchange Board of India (SEBI) sought to regulate algo trading, short for algorithmic trading.

What is Algorithmic Trading?

Algorithmic trading refers to stock trades made by computer algorithms. Computer programs contain pre-written rules about buying, selling, and other strategies, allowing for lower human intervention in the trades.

These instructions are usually decided for varying market conditions, price points, trends etc. The SEBI had allowed algorithmic trading in India in 2008, but programmed trading saw increased traction in the last few years.

As a larger number of tech-savvy retail investors entered the market, with broker providing options for algorithmic trading, the segment saw higher volumes. Currently, algo trading contributes to around half of the market’s trading volumes.

Algo trading’s popularity comes from the fact that the programs execute trades within a fraction of a second, unlike humans who would take time to perceive data, process it, make a decision, and execute it.

Why is SEBI Looking to Regulate Algorithmic Trading?

The high volumes contributed by algorithmic trading, combined with the increasing adoption by retail investors, has alerted SEBI. In recent years, with major brokers reducing charges, and introducing options to run trading programs on their platforms, several traders have begun selling these programs to investors. Several of these programs come with “guaranteed” minimum returns, which is almost impossible in the stock market.

“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. The potential loss in case of failed algo strategy is huge for retail investor,” said the consultation paper. The providers of such third-party trading software are unregulated, making consumer redressal difficult the paper added.

Hence, SEBI has decided to intervene. Unlike humans, computers do not think for themselves, and execute order once certain conditions are met. As a consequence, the algos could increase systemic risk or be used to manipulate markets.

For instance, a practice known as “spoofing” is used by traders to manipulate markets. Spoofing algorithms create a false perception of supply and demand, causing prices to move significantly.

What does SEBI’s Consultation Paper Suggest?

So far, SEBI’s consultation paper has suggested that algo strategies and programs are reviewed by exchanges and the regulator before being allowed in the markets. Each algo would also have a unique code, and would have to be routed through India brokers’ servers.

Exchanges, too, would have to implement risk control mechanisms to address any potential issues emanating from the algos. In case of exingencies, due to the algo, the broker terminal would be shut off.

Third-party training programs are run using Application Programming Interfaces (APIs) that connect clients to brokers. However, both algo and non-algo offers emanate from APIs, making it difficult for anyone to differentiate between the two orders.

As a result, SEBI has asked that all orders coming through APIs should be considered algo orders. Hence, brokers would have to take permission for all algo strategy. The regulator has suggested several other changes as well to bring third-party algo providers under its gambit as well.

Brokers Highlight Problems

Brokers are not too happy with the suggested changes. They have argued that the procedure for receiving approvals for different algos is quite a complicated and tedious process. In effect, brokers might stop offering APIs altogether if the proposals are implemented in the Indian markets.

Several brokers have also said that taking a blanket decision based on a few cases could be unfair. Nithin Kamath, the founder of online discount brokerage Zerodha, has suggested alternatives to such regulations that put the capital markets “backwards”.

“Disallowing APIs will also not solve the problem of unregulated algo trading platforms. They will just shift from using broker APIs to third party automation tools which aren’t in the control of the brokers, said Kamath in a public post.

He added that "the only way to solve this problem is by regulating these algo platforms and bringing them under the RIA/RA framework, which will put restrictions on the way some of these platforms are currently misselling algos as almost an easy and guaranteed way of making money, which isn’t true.”