Regulation of Algo Trading

Why in news?

The Securities and Exchange Board of India (SEBI) has issued a discussion paper on regulating algorithmic trading.

Algorithmic trading or Algo trading is computer assisted buying and selling of stocks.
It is also known as automated or programmed trading, since trades are generated out of automatic execution of pre-programmed computer strategies based on set of parameters, instructions or market pattern and conditions.
Algo trading came to India in 2008, but only savvy traders were using it then.
In the past 5 years, retail traders have started using advanced algos for trading mainly due to its speed of order execution.
Before algos came into play, retail traders had to either call their brokers to execute trades or be physically present at the nearest broker's office.

Traders can deploy their pre-programmed algorithms by connecting them to a broker's trading terminal, which is in turn is linked to a stock exchange server.
The Algo trading system automatically monitors the live stock prices and initiates an order when the given criteria are met.
This frees the trader from having to monitor live stock prices and initiate manual order placement.
Mobile trading is also a form of algo trading, where orders are executed via apps.
Order execution without human intervention is an advanced form of algo trading. Around 50% of the daily trading volume in Indian stock markets is through this form.

SEBI and stock exchanges regulate and monitor broker terminals, but the algo programmes deployed by traders did not require any exchange approvals so far as there were no rules.
But SEBI now believes that unregulated/unapproved algos pose a risk to the market as a number of cases have been reported of retail clients losing money based on false promises made by some vendors.
The unapproved algos can be misused for systematic market manipulation as well to lure retail investors by guaranteeing them higher returns.
As Algo programmers sell their strategies like assured return products, the potential loss in the case of a failed algo strategy is huge for retail investors.
Algo trading became controversial in 2015, when it was revealed that NSE gave preferential access to a few algo traders.

SEBI wants every algo trading strategy and programme to be approved by the exchanges before they are deployed by traders.
It has also said that there should be clarity on whether the services offered by third-party algo providers are in the nature of investment advisory services based on research and analysis done by them.
It wants the exchanges to develop a system to ensure that only those algos which are approved and have a unique ID are deployed.
Also, brokers will deploy suitable technological tools to ensure that appropriate checks are in place to prevent unauthorized altering or tweaking of algos.
Currently, exchanges are providing approval for the algo submitted by the broker.

Brokers say algo trading volumes could fall once the proposed SEBI norms are implemented, since approval of pre-programmed trading strategies by the exchanges could be a complex affair.
Also, submitting algo programmes to exchanges for their approval, would mean that vendors may have to reveal their formula.

Reference