Long Overdue Process of Regulating Retail Algos Begins
The Securities and Exchange Board of India (SEBI) has been meeting various algo retailers and brokers to examine what kind regulatory framework is needed. After I flagged the issue in July this year, several developments may have nudged the regulator to act, before it is forced to react to a possible debacle. The process of skirting regulatory oversight today happens at multiple levels and needs to be fixed in its entirety. So, let us look at the market first.
 
Almost all the top brokerage firms offer algo trading to individuals through APIs (application programme interface) as well as a direct web interface. Algo trades (retail and institutional) account for 80% of cash traders on the National Stock Exchange (NSE). Brokers are actively encouraging the business, since rapid, programmed trades generate high volumes and fees, essential to discount brokerage firms.
 
Naturally, brokers have found innovative ways to get around SEBI’s stringent rules applicable to client interaction. They enter into deals with algo retailers who are often small tech firms that code different trading strategies into an algorithm and offer them to retail investors as a fee-based product. Brokers sign up algo retailers as remisiers (a remisier is a commission agent for a stockbroker who earns a fee for bringing in new clients).These algo retailers then market the product, refer clients and even demand a profit-sharing arrangement on successful algos. The broker gets to skirt sub-broker rules, while investors are allowed to believe that a remisier is a SEBI-registered sub-broker.
 
In the ferocious bull market today, it is easy to entice people, especially youngsters and first-time investors, so much so that the entire referral, pass-back and commission business involving retail algos has become like a multi-level-market operation, says an industry source. Although monthly subscriptions for algos range between Rs500 and Rs1,200, many firms recover marketing costs and generate revenues by levying hefty start-up fees. There are no contracts, almost no documentation and certainly no effort to understand the investor’s risk-taking ability.
 
According to a source, nearly 40 algo retailers are offering over 350 different algo strategies that are completely out of regulatory purview today. There are over 100,000 active retail traders in the market, playing the algo game, with a capital of a couple of lakh rupees at the lower end, to even Rs100 crore at the high net-worth individual (HNI)-level. The more aggressive algo retailers have been promising guaranteed returns (as high as 10% to 15% per month) with no disclaimers about market risk. The sales pitch is based on back-tested data which may be distorted using convenient data points.
 
Conscientious algo retailers are aware that they are operating in a dangerous grey area and problems with one unscrupulous entity will taint the entire business. They have been pressing SEBI for a regulatory framework, while others have quietly registered their firms abroad to avoid problems. Some SEBI officials seem to believe that algo retailers are already covered by investment advisory (IA) regulations, given that they cover robo advisory. This is alarming, since it is a virtual free-for-all in the retail algo business, while the regulator has imposed onerous rules, qualifications, documentation and conditions for investment advisers.
 
Sensible algo regulation would require SEBI to frame rules that require some registration, qualification and compliance requirements for algo retailers, while also making them responsible for the investment advice coded into their algos. Bringing algo trading under IA regulations cannot possibly work. IAs today face stifling rules of documentation, such as storing for five years, each piece of advice offered to each client, signed by the adviser, whether physically or digitally, which would be impossible when hundreds of trades are fired in a minute for all clients through an algo.
 
Here are some issues and possible solutions.
1. Algo retailers do not even require any registration or documentation, as opposed to RIAs (registered investment advisers) and RAs (research analysts) who are subject to capital adequacy, educational qualifications and market certification requirements. This needs to change.
 
2. Algo retailers have no know-your-customer (KYC) requirement while signing up customers, no documented risk-profiling of clients, or suitability and justification of investment advice. This yawning gap needs to be bridged urgently, while also ensuring that the cost of being compliant is not so high that it forces smaller coders to go underground and operate informally. This is already happening in the investment advisory business.
 
3. Algo retailers are allowed to have referral and commission relationships with scores of brokers. This will need to be become transparent and in line with rules for other intermediaries with appropriate checks & balances.
 
4. Many registered sub-brokers are executing trades for investors since algo retailers have enabled multiple trading accounts (called multiple deployments) on a single device. This has turned them, as well as algo retailers themselves, into portfolio managers in a high-risk trading activity. In contrast, many genuine portfolio managers had to stop business due to SEBI’s absurdly high, minimum portfolio size of Rs50 lakh (up from Rs25 lakh earlier) and capital adequacy rule of Rs3 crore. SEBI has refused to budge, even though investors with a portfolio size of Rs10 lakh were deprived of quality advice. In contrast, an algo retailer or sub-broker could corner their business with no rules or regulatory oversight.
 
5. Since algo retailers are not even registered, they are not subject to disclosure rules about their proprietary trades and there is no scrutiny about whether they use better algos on proprietary trades or even benefit from trading patterns coded into the algos offered to clients. There are no rules to regulate data accessed from clients when they subscribe to algos. Algos can easily be coded to execute pump-and-dump operations, and aid tax evasion, say insiders. Since there is no scrutiny, the regulator and investigation agencies are clueless about potential abuse.
 
6. Most traders are also unaware that any trading glitch or disruption in data feeds can cause the algorithm to malfunction and could lead to heavy losses. This was evident in the outrage on social media over the sudden spikes in prices. As it turned out, institutional investors operating out of co-location servers getting access to very granular data feeds were able to capture multiple profit opportunities (retail data is updated every second while institutional algos are programmed to execute very large trades in micro-seconds –1,000,000th of a second) showing a sharp spike when retail data was updated.
 
The way forward is for SEBI to come up with a quick framework for registering algo retailers who provide research or investment advice in the form of a coded trading strategy. This framework needs to cover registration as well as execution of trades. A more complicated task would be for SEBI to find a way to track which trades are generated through APIs. Exchanges already have a different format for identifying trades emanating from co-location servers and it can find a way to format order numbers for API-based trades, say tech experts.
 
The framework needs separate registration for investors seeking APIs for algo trading and needs to cover scrutiny of algos, who will be responsible for clearing algos and what kinds codes would be considered illegal (those aiding manipulation, tax avoidance, etc). Algo retailers are also requesting trading limits for investors so that their entire capital is not wiped out in a day because of an algo gone rogue or sudden price movement.
 
A senior SEBI official had told me that retail algos don't need regulation. It’s good that a simple fact has dawned on SEBI officials– algos offer buy/sell recommendations and, therefore, need to come under some regulation. But the regulator will also need to create a level playing field between traditional RAs, RIAs and portfolio managers by relaxing some of the stifling regulation applicable to them and bringing it on par with any new framework that it proposes for this new generation trading activity.
 

Comments
k.v.mehta
22 hours ago
Ms. Dalal, completely agree with your point of view. Aside from being dangerously unregulated, this is a classic example of perverse regulatory outcomes that are preventing the sustainable growth of investment advisory industry in India (no wonder there are just c.2000 RIAs in India, whereas there should be 2 lakh). Also, as you mentioned - SEBI's RIA rules are completely asinine and have created unnecessary entry barriers for start-up RIAs who are seeking to offer quality advise to clients. The fact is that no where in the world does the regulator prescribe a minimum investment amount for an investment product, so why are we doing it in India ? Suitability needs to be regulated at the investor level (through investor accreditation or other similar standard) and not at the level of the product.
saran2sai
1 day ago
The zoo keeper example is very pertinent.
rajnishsapra
2 days ago
Minor fact correction needed in the article — a microsecond is a millionth of a second, not a thousandth.
sucheta
Replied to rajnishsapra comment 2 days ago
Thank you. Corrected.
Kamal Garg
2 days ago
In these times of frenzied bull run and every day ever all time market tops, whether you put a sensible/non-sensible system/surveillance mechanism to curb and control the market is futile at the least. Market will learn its own lessons once the bull stops rampaging the market and people start feeling the burn holes in their pockets. This will happen all of a sudden once the liquidity influx is controlled by the central banks and economic growth starts moderating with high inflation; which is by-the-way around the corner.
jusojosu
2 days ago
In a zoo, you can't expect the zookeeper to teach all those wild animals out there the t&c for their expected behavior while in the zoo, but the zookeeper knows it is their responsibility to provide a safe environment for the visitors without expecting the animals to behave in a mannerly way.

Asking SEBI to monitor each and every algotrade account is like asking this zookeeper to teach the t&c to each of his animals.

SEBI should ask the exchanges that even if the lion and tigers gets out of its cage, they should have monitoring and safety measures in place that no one else becomes a victim.
jusojosu
Replied to jusojosu comment 2 days ago
Like a famous person once put it, "Sometimes people are afraid if those crawling ants on your house floor is about to bite you that you get busy thinking of ways to get rid of them, while forgetting to notice that big crack on your roof that is about to bring the whole roof on your head sooner than those ants could bite you. " The financial market has got bigger problem to worry out at the moment.
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