Regulatory Framework for Algo Trading: SEBI

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    In News 

    • Recently, the Securities and Exchange Board of India (SEBI) proposed that all orders emanating from the Application Programming Interface (API) of stockbrokers should be treated as Algorithmic Trading or Algo.

    What is Algo Trading?

    • It refers to orders generated at superfast speed by the use of advanced mathematical models that involve the automated execution of the trade. 
    • It automatically monitors live stock prices and executes a trade upon fulfilment of specific criteria. 
      • This frees the trader from having to monitor live stock prices and initiate manual order placement.
    • It provides profit opportunities for the trader.
    • Benefits of Algorithmic Trading
      • Trades are executed at the best possible prices.
      • Trade order placement is instant and accurate (there is a high chance of execution at the desired levels).
      • Trades are timed correctly and instantly to avoid significant price changes.
      • Reduced transaction costs.
      • Reduced risk of manual errors when placing trades.
        • Reduced the possibility of mistakes by human traders based on emotional and psychological factors.

    Major highlights of SEBI’s  proposal 

    • All orders emanating from an API should be treated as an Algo order and be subject to control by the stockbroker.
    • The APIs to carry out Algo trading should be tagged with the unique Algo ID provided by the stock exchange granting approval for the Algo .
    •  Stockbrokers need to take the approval of all Algos from the exchange.
      • Each Algo strategy, whether used by broker or client, has to be approved by exchange and as is the current practice
      • Each Algo strategy has to be certified by Certified Information Systems Auditor (CISA)/ Diploma in Information System Audit (DISA) auditors.
    • Stock exchanges have to develop a system to ensure that only those Algos which are approved by the exchange and have unique Algo ID provided by the Exchange are being deployed. 
    • All Algos developed by any entity have to run on the servers of brokers wherein the broker has control of client orders, order confirmations and margin information. 
      • Two-factor authentication should be built in every such system which provides access to an investor for any API/Algo trade.

    Need for Formulating a Regulatory Framework

    • The SEBI has drawn the regulatory framework to make Algo trading safe, protect retail investors’ interest and prevent any possible manipulations in the market.
    • Currently, exchanges provide approval for Algo trading, which are designed and coded by the brokers. 
      • However, for trading done using APIs by retail investors, neither brokers nor exchanges can identify if the particular trade is an Algo or non-Algo trade.
        • This kind of unregulated and 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. 
          • The potential loss in case of failed algo strategy is huge for retail investors. 
        • This is coupled with the risk that as most of the third-party Algo providers are unregulated, there is no grievance redressal mechanism for a retail investor.
        • Therefore the SEBI has proposed a regulatory framework to mitigate the threat.

    Impact on 

    • Businesses:
      •  It’s an opportunity for brokers who are offering APIs to customers to craft their own Algo trading strategies as it will help them strengthen their technological prowess and expand their client base.
      • With chances of manipulation going down by several notches, they can reach out to more customers and assist their investment needs by helping them customize their trading strategies.
      • It will allow brokerage houses to offer algorithmic services to their retail clients, instead of only institutional investors, who are currently covered by regulations. 
      • However, as getting the requisite permission from the stock exchanges is a tedious process, brokers may have to stop using the API system.
    • Retail Investors:
    • The proposal is definitely a step in the right direction as far as the interests of retail investors are concerned.
    •  It ensures that retail investors are protected and it ensures their suitability as well. 
    • The regulation will increase the confidence of retail investors who wish to undertake Algo trading. 
    • With a set of rules in place, there won’t be any price manipulations and the investors may not have to incur any heavy losses in the process.
    • However, there’s a chance that investors might shift to some other system if API is not allowed and putting restrictions will impact the development of the market.

    What Application Programming Interface (API)?

    • It is a set of programming codes that queries data, parse responses, and sends instructions between one software platform and another. 
    • APIs are used extensively in providing data services across a range of fields and contexts.
    • Many brokers in India have started providing Application Programming Interface (API) access to their clients which establishes an online connection between a data provider (stockbroker) and an end-user (client). 
    • API access enables the investors to use a third-party application that suits their feature needs or investors who have technological capabilities to build their own front-end features.
      •  These third-party applications help an investor analyse market data or back-test a trading or investment strategy. 
    • These APIs are being used by the investors for automating their trades.
      • Presently, though the broker can identify the orders emanating from an API, they are unable to differentiate between an algo and non-algo order emanating from an API.

    Securities and Exchange Board of India (SEBI)

    • It was established on April 12, 1992, in accordance with the provisions of the Securities and Exchange Board of India Act, 1992.
    • It is a statutory body that is constituted as the regulator of capital markets in India under a resolution of the Government of India.
    • Aim: To protect the interests of investors in securities and to promote the development of, and regulate the securities market.
    • It is the regulator of the securities and commodity market in India owned by the Government of India

    Conclusion 

    • The SEBI has sought public opinion on the proposed framework by January 15, 2022. 
      • The regulator will consider the views of all the participants before the final framework is rolled out for implementation.

    Source: IE