The Securities and Exchange Board of India (SEBI) has finally released a draft framework to regulate retail algo trading after pressure from the public, key whistleblowers and organisations such as Moneylife.
The consultation paper on algorithmic (algo) trading by retail investors, released for discussion yesterday, recognises that retail investors are increasingly using third-party algorithms from algo writers and vendors, without these being approved by the regulator or stock exchanges.
The framework proposed by SEBI seeks to label all orders from an application programme interface (API) as algo order and mandates pre-approval from stock exchanges for algo-trading that would be tagged with the unique algo ID. Further, stock exchanges can give recognition only to brokers and not to any third party algo provider or vendor who creates the algo.
In July this year, we had highlighted how retail investors were using off-the-shelf algos that are being offered by dozen-odd algo-writing platforms, which are entirely outside the purview of regulation. As many as 40 top brokerage firms offer algo-based trading to clients, and there was no clarity on the number of firms writing such algos. (Read: Why Is SEBI Reluctant To Regulate Retail Algos?
At that time a SEBI insider said that the regulator had decided there was no need to regulate retail algos. However in the next few months SEBI officials held meetings with algo writers, including those like Dharmik Thakkar, a whistleblower quoted by us to understand the issues involved and how retail algos could be regulated.
The SEBI paper says, “...unregulated or 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 the retail investor. Since these third-party algo providers and vendors are unregulated, there is also no investor grievance redressal mechanism in place. Hence, to make the algo trading safe for retail investors and also to prevent market manipulations, it is felt that there is a need to create a regulatory framework for such algo trading.”
At present, exchanges are providing approval for the algo submitted by the broker. However, SEBI says, for the algos deployed by retail investors using APIs, neither exchanges nor brokers are able to identify if the particular trade emanating from API link is an algo or a non-algo trade.
SEBI defines algorithmic trading as any order generated using automated execution logic. And API allows an individual to access brokers’ trading platforms without logging in manually. The algo writers usually show a back-tested report on trading strategies to sell the idea that you can make a lot of money on rapid intra-day trading.
SEBI had constituted an internal working group that deliberated on unregulated algos being used by investors, especially retail investors, and ways to prevent the same. The working group held meetings with various market participants and based on deliberations, the working group submitted their recommendations.
As per the proposed framework, the stock broker needs to take approval from the stock exchange for all algos. 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 a certified information systems auditor (CISA) or auditors holding a diploma in information system audit (DISA).
Further, stock exchanges have to develop a system to ensure that only algos that are approved by the exchange with a unique algo ID is used. The market regulator says that brokers should also deploy suitable technological tools to ensure that appropriate checks are in place to prevent unauthorised altering or tweaking of algos.
Here are other recommendations made by the SEBI working group...
• All algos developed by any entity has to run on the servers of broker, wherein the broker has control of client orders, order confirmations, and margin information.
• Stockbrokers need to have adequate checks in place so that the algo performs in a controlled manner.
• Stockbrokers can either provide in-house algo strategies developed by an approved vendor or outsource the services of a third-party algo provider or vendor by entering into a formal agreement with each third party algo provider or vendor whose services are being availed by the broker.
• The stockbroker is responsible for all algos emanating from its APIs and redressal of any investor disputes.
• Obligations of a stockbroker, investor and third party algo provider or vendor need to be separately defined. The stockbroker is responsible for assessing the suitability of the investor prior to offering an algo facility. No recognition shall be given by the exchange to the third party algo provider or vendor creating the algo.
• Stockbrokers shall ensure that only those third-party algo providers or vendors, with whom the broker had entered into an agreement with shall use the name of the broker as part of their testimonial, provided exchange prescribed advertisement guidelines are met.
• Two-factor authentication should be built in every such system, which provides access to an investor for any API or algo trade. The software to be used to create the strategies should be approved by the exchange.
• Stockbrokers shall include a specific report on algorithm checks implemented by them as a part of the annual system audit report submitted to the exchanges and the format for the same shall be prescribed by the exchanges.
Further, SEBI says there is a need for clarity on whether the services offered by the third party algo providers and vendors are like investment advisory services.
It asked brokers to obtain from their clients’ details of the nature and type of services taken from algo providers along with a confirmation as to whether the said services are in the nature of investment advisory services. “Such details obtained by the broker would help in the formulation of policy framework, if felt necessary, regarding third-party algo providers in future,” SEBI says.
SEBI says comments on the consultation paper on algo trading by retail investors can be sent by e-mail or through the post before 15 January 2022. While sending comments through e-mail, kindly mention the subject as “Algorithmic Trading by Retail Investors.”
Dharmik Thakker, the founder of Algomaker, an algorithmic trading firm that writes code and creates trading strategies for retail clients, has been blowing the whistle on the absence of regulation by writing and attempting to engage with the regulator. According to him, API-based algos can run on any scrip, including penny stocks, and to manipulate a stock using algos, all one needs is multiple user accounts on which any algorithmic strategy can be deployed.
Mr Thakker believes that even innocent investors can become pawns of such algos because end-users may be clueless about the exact trading strategies that they end up deploying. He had prepared a case study by placing an order in ‘stock X’ with 40 user accounts that subscribed to his service, which shows how bulk orders through the algo could be easily used for market manipulation.
Some algo makers have been advertising their products and charge about Rs500 a month to subscribe to an algo. They have also partnered with dozens of top brokerage firms to ensure direct integration with their platforms through a ‘bridge’. The retail client, thus, has a turbocharged system to earn a living by day-trading. But nothing is sure-shot in the markets; many incur large losses, as evident from the anger that spills into social media platforms every time a new break or a tech glitch upsets the programmed logic.
Such discretionary algos, claiming to make money and generate returns, have been sucking people into trading in the past couple of years. While some say that the algo market for retail investors is still small, with each broker having a few thousand clients, this is actually growing very fast. Dharmik says that, based on NSE data, that the current size of portfolio handled by API-based algo strategies is 20% of the trading volume. (Read: Why Is SEBI Reluctant To Regulate Retail Algos?)