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This article has been written by Sonia Bohra pursuing a Certificate Course in Introduction to Legal Drafting: Contracts, Petitions, Opinions & Articles. This article has been edited by Prashant Baviskar (Associate, Lawsikho), Ruchika Mohapatra (Associate, Lawsikho), and Indrasish (Intern, Lawsikho).

This article has been published by Sneha Mahawar.

Introduction

The securities market of India is undergoing various changes over the last decade. Dealing with securities buying as well as selling of shares, mutual funds, etc, and the stock exchanges depositories come under the “Securities Exchange Board of India”, (SEBI) consisting of various regulations, guidelines of SEBI (SEBI Act, 1992).  Protection of interest of investors and promotion and development of securities market are prime objectives of the SEBI.  The constant growth of technology and innovations are designed to reduce costs in the securities market which force investment firms and advisors of institutional investments to rethink the trading operations. Hence advanced technologies and algorithmic trading has built a new industry in the securities market. 

Algorithmic trading” is rapidly becoming a mainstream response for institutional investors where huge blocks of shares are moved with fewer transaction costs. Where computer codes and software are required to open and close trading in the securities market in accordance with the set of rules which point to price movement in the market, it is known as algorithmic trading. When the predetermined price criteria are matched in the current market, these algorithms (algos) can place buying and selling orders, instead of you manually scanning the markets. This reduces human error, saves time, and also requires low maintenance. Algorithmic trading is popularly known as an automated trading system that consists of formulas and results of mathematical finance and relies upon specialised software.  

For example, purchase 50,000 shares of Reliance (RIL) if the price of shares falls below 100. Then purchase 500 shares for every increase of 0.1% of the price above 100 and sell 500 shares for every 0.1% decrease of the price below 100.

Mutual funds, banks, insurance companies, hedge funds, and other institutions, etc make high-volume trades that are impossible to do manually. Platforms that offer algo trading services are 5paisa, Fox trader Algo Trading Platform, Zerodha, Alice Blue Algo Trading Platform, Master Algo Trading Platform, etc.

Algo Trading in India

In the year 2008, SEBI introduced Algo trading, and “Direct Market Access” (DMA) was started which gave permission to the brokers for introducing their infrastructure except to retail customers.

In 2010, SEBI introduced “Smart Order Routing” (SOR) which overnight enabled the investors in placing trade orders without hesitating which exchange was providing better securities price. 

In 2011, the percentage of the turnover was increased to over 50% of BSE’s equities which were based on algo trading. Soon co-location was also introduced which provided members within exchange premises a facility of having their own servers.

Working of Algo Trading

When an offer is made by a broker of an algo (to buy and sell), the algo requires the approval of the SEBI. It is applicable if the broker uses such algo for his own proprietary trading (prop trading) or when he offers to investors. When the offer is made by the broker, the program will run on the broker’s systems and when the signal is generated by the algo, an order is automatically executed on the investor’s account without the involvement of the human.

Indian brokers have now started providing an “Application Programming Interface” (API) for their clients which makes online connections between a stockbroker and his client. “Application Programming Interface” (API) is a software intermediary where two applications can talk with each other. When you send a message through WhatsApp, Facebook, or checking whether on your mobile phone, you are using an API.  For example, when we log in Facebook/Google/Twitter etc, API is used while loading such applications to ensure that the user has logged in or not. If not then, when the user logs in, a pop-up is displayed for the confirmation that the user wants to log in to his profile. When the confirmation is given by the user, information of identification is provided by API to the application, and hence it knows who has logged in. 

Several traders use third-party applications for accessing the broker APIs for performing trades. A trader is allowed in the trading API to write his own computer programs for placing trades. These APIs help the traders in making their own applications for executing a trade.

At present brokers submit algos which are approved by the exchanges.  However, retail investors who deploy algos with the help of APIs, exchanges as well as brokers cannot identify whether the trade emanating from the link of an API is an algo/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. There can be huge losses to the retail investors if there is a failure in the algo strategy due to unregulated third-party algo vendors/providers and no grievance redressal mechanism is provided for such investors.

Proposal by SEBI

The orders which are emanating from an API shall be known as algo orders. The stockbroker shall control these algo orders. After granting approval from the stock exchange, a unique Algo ID will be provided to the API that carry out algo trading by this Stock Exchange. Brokers, as well as clients, shall require the approval of the stock exchange for each algo strategy and a Certificate of certified Information Systems auditor or diploma in information system audit by the auditors shall be required for these algo strategies. Proper technological tools shall be deployed by the brokers to ensure the placement of appropriate checks for the prevention of unauthorised alteration or tweaking in such algos. 

The server of the brokers shall run all the algos and brokers shall have control of all the margin information, confirmations of the client’s order, etc. Inhouse algo strategies shall be provided by the stockbrokers which are developed who approved vendors and stockbrokers can also outsource such services by entering a formal agreement with third party algo vendors. The stockbrokers shall be responsible for all the algos emanating from their APIs and shall also be responsible for disputes with the investors. Obligations of investors, third-party algo vendors as well as stockbrokers shall be defined separately.  Every system shall have two-factor authentication that will provide access to any algo trade to the investor. The software that creates strategies shall require the approval of the exchange.  The annual system audit report shall include a report of algorithm checks in a prescribed format implemented by the stockbrokers and shall be required to be submitted to the Exchange.

Concerns relating to the proposal

It shall be unfair if all the API-based trades shall be classified as algo trades. API itself is a whole market. This will retard the connection between sophisticated players and brokers who are connected with each other due to purposes other than algo trading. 

The Proposed Framework has imposed a heavy burden on the brokers as they have to now ensure that persons who are using algos developed by third-party vendors are approved by the stock exchange. The cost required for the approval process will now have to be followed each and every time when the algo strategies are changed with the changing investment strategies which is a burden on the traders, brokers, developers, and also on the stock exchange.

Impact on Retail Investors

The proposal is a step in the right direction as far as the interests of retail investors are concerned. The regulation not only ensures that the retail investors are protected but also it ensures their suitability as well. The regulation will increase the confidence of retail investors inclined towards undertaking 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.

The impact of the move could be two-fold: First, it may increase compliance costs for Robinhood-type brokerages that are seeing an influx of new clients because they offer cheap trading based on machine-generated strategies. Second, it will allow traditional brokerages to offer algorithmic services to their retail clients, as opposed to only hedge funds and other institutions that are covered by regulations so far. While Sebi’s intention is right, its decision to consider all API-based trades as algos can be bad for the entire ecosystem and stifle innovation. 

Conclusion

The third-party trading apps which are unregistered/unregulated with the exchanges are a threat to the Indian securities market.  Such apps are infringing the guidelines and promising retail investors to offer them higher returns. Such types of apps promise retail investors to provide them four-digit returns by making investments of double-digit. These apps are the demons in the stock market which damage the faith of the investors in the capital markets.

Since these are unregulated apps of trading, they attract many traders, as well as investors, and errors made by these traders and investors in Algo trading will trigger several wrong trades at the same time. The market can be manipulated by these unregulated algos in several ways since they hold a huge number of investors. Hence putting restrictions will have a positive impact on the growth and development of the securities market. 

SEBI should, with the consultation of relevant market participants, provide a mechanism that does not hinder the growth of technology and also ensures the protection of the investors as well as their integrity simultaneously.

References


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