Who Is against SEBI’s Move To Regulate Retail Algos? Are Their Fears Justified?
On 9th December, the market regulator put out a discussion paper on regulating algorithms (algos) for retail investors after several algo-writers had pushed for clarity on their role, responsibilities and, more importantly, liability. 
 
An algorithm codes a certain price pattern to trigger automated execution of trades. There can be hundreds of such patterns and India now has a mushrooming industry of writing these programs that are wildly popular with retail investors. Algos are offered through brokerage firms with the application programming interface (APIs) providing seamless connectivity between investors using such algos and the broker platform.
 
As retail algos exploded, unscrupulous algo-writers began to lure newly-minted investors with the promise of high returns. I spoke to a cross-section of market participants for feedback on the issues that led to the consultation paper issued by the Securities and Exchange Board of India (SEBI). Saurabh Lohia of Algoji Enterprises, whose flagship product is integrated with 60 broker APIs, succinctly enumerates various reasons why regulation of retail algos is necessary: “Many algo platforms falsely promise ‘consistent and astronomical’ returns. Some have back-testing of strategies that is ‘curve-fitted’ to mislead investors about returns; there are poor risk disclosures; there is no clarity on whether customer data (shared between brokers and algo-writers) is misused for proprietary trading and front-running a certain strategy deployment.” 
 
This led to fears that rogue algos could cause widespread losses and trigger a regulatory backlash that would hurt genuine participants as well. Consequently, some algo-writers, such as Dharmik Thakkar of Algomaker, approached SEBI seeking clarity on regulation. After some prodding, SEBI began (Read: Why Is SEBI Reluctant To Regulate Retail Algos?) a dialogue with market participants leading up to the framework that is now up for discussion. 
 
Curiously enough, media headlines about SEBI’s consultative paper seem largely negative, with market participants making contradictory points based on their business interests. At a time when India’s investor population has doubled in less than two years, some have even claimed that regulation will put off retail investors! 
 
SEBI’s job, as enunciated in the preamble of its statute, is to protect investors and ensure a fair and orderly market. It has no mandate to facilitate higher turnover and profits for exchanges and brokerage firms. It had a duty to act when novice traders are made to believe that an algo subscription is all it takes to put them on par with investment experts who have spent decades analysing markets and honing their trading skills.
 
Contrary to the media headlines, my interaction with market participants indicates strong support for a regulatory framework, although some proposals need more clarity and there are worries about whether compliance and clearance process would lead to higher costs and delays. The draft regulations, as a first step, also recognise the need to level the playing field between investment advisers, who are subject to onerous restrictions and compliances, and algo-writers who are not regulated, but offer computer-coded trading strategy which is a form of investment advice. 
 
Let us look at the key issues of contention.
 
Broker-focused Regulation: The draft regulatory framework, correctly, has brokers as the focal point, making them responsible for most compliances. The public debate is focused on the proposal that all orders from APIs will be considered algo trades. At present, brokers insist that, although they are able to identify orders emanating from APIs, they “are unable to differentiate between an algo and non-algo order emanating from an API,” says the SEBI paper. Algo-writers, however, insist that almost every one seeking an API is trading algos – it may be an algo written by an individual for personal trading or part of the thousands of ready-made algo strategies available for subscription today.
 
The draft paper puts the onus on brokers to ensure the following: that retail algos are cleared by the exchange; that each order has a unique algo code; that algos are certified by a systems’ auditor and cannot be tweaked or altered after approval; and that the broker redresses investor disputes. All algos have to run on the servers of brokerage firms, who will also have control over order confirmations, margin information, etc. Brokers have also been made responsible for suitability of a product for the investor and to ensure that algos offered by them follow advertising norms of exchanges.
 
Putting brokers at the centre of retail algo regulations is logical, since investors sign comprehensive agreements with them; but the largest brokerage firm, Zerodha, finds this proposal extremely irksome. In July this year, Nithin Kamath, founder of Zerodha, told me that his firm offers APIs for a fee, but does not allow direct integration from its own platform. A person paying for the API, however, has the option to integrate it with any algo service. Mr Kamath has called SEBI’s decision to consider every API an algo a backward step. Curiously however, Zerodha-promoted Streak.tech is a highly popular platform for providing all the tools, strategies, back-testing and deployment for those who create their own trading strategies and algos. Streak and has over 30,000 active users operating under the internet-based trading (IBT) clearance offered by exchanges since 31 January 2020, without needing each strategy to be individually approved, say algo-writers. The IBT clearance allows SEBI-registered brokers to offer internet-based trading, subject to certain conditions.
 
Perhaps Zerodha wants to delink Streak from its core brokerage business; but the new rules may force it to take responsibility for regulatory compliance from customers who take an API to automate their trading. However, since Zerodha also insists that the number of investors seeking direct APIs is very low, it cannot be badly affected by SEBI’s attempt to frame rules and responsibility.
 
Other large brokerage firms seem to have adopted a different model. They offer platforms or marketplaces selling algo strategies as well as their own algos developed in-house. The new regulations provide for both options to be offered legally. When detailed regulations are framed, SEBI should ensure legitimate subscription and fees for algo retailers/writers and end the dubious practice of signing them up as remisiers (commission agents for a stockbroker who earns a fee for bringing in new clients).
 
Brokers, who offer a marketplace of algos, are already taking responsibility for getting exchange approvals under the board umbrella of IBT clearances. The moot question is whether this will continue under the new rules or will processes be tweaked. Saurabh Lohia says that current approval process for algos and trading software is a quick and inexpensive. His firm provides algo strategies through 40-odd brokers and his personal experience is that IBT approval happens in as quickly as one working day and does not cost any money. Also, when an algo, that is already cleared, is submitted for approval by other brokerage firms, exchanges are pragmatic enough to ensure fast clearance. 
 
There is currently no provision for individual algo strategies being approved for the retail segment, although there is a history of delays and harassment and anti-competitive practices by exchanges with regard to the institutional algo section. Exchanges already provide UAT (universal acceptance testing) environment for approving apps and encouraging innovation, says Mr Lohia.
 
Those opposed to SEBI’s move to treat all API-linked trades as algos suggest alternate checks & balances to prevent market abuse and manipulation. These include: strict restrictions on API-based orders, maximum order limits per minute or per day and speed bumps or delays to limit large trading volumes. However, implementing and auditing these will, probably, place as much of a burden on brokerage firms and will require SEBI to rework the entire regulatory framework attracting similar resistance. 
 
In the three decades of tracking the market regulator, the one constant is that every effort to expand SEBI’s regulatory ambit meets with strong resistance and polarised views on the very need for regulation and its contours. This time, despite the noise in the mainstream media, the request for a regulatory framework has emanated from the industry and has broad-based support in its present form, with some quibbles about form, processes and implementation. SEBI needs to follow it up by ensuring that the approval process is swift and encourages innovation, while making markets safer for investors.
 
Viewers interested in a discussion can watch this animated discussion with me on Zoom: https://youtu.be/4bjRC2MkxsU
 
 

Comments
vini.bright.ideas
5 months ago
Trading strategies have 2 sides experience and logics. Logics or assumptions are backtested and different items of assumptions are given weightages, which is again individualistic to the research expert which is based on Investor Psychology and experience. Also to add, like in every industry, there is always co-existence of good and bad, which needs to be regulated in consumers ( here investor community) and hence anything that happens in interest of investor community should be accepted, may be with a pinch of salt, but take it this way that fly by night guys should be out and there would be market expension. I personally feel it is a good move.
chandragupta
5 months ago
I bring your attention to the following sentence from the article - "SEBI’s job, as enunciated in the preamble of its statute, is to protect investors and ensure a fair and orderly market. It has no mandate to facilitate higher turnover and profits for exchanges and brokerage firms".

So the question is - Why should algos even exist? Is it "investing"? What is the economic justification for algos? Is it not the same as creating robots who can eat, just so that restaurants remain in business? Creating artificial liquidity in stocks where none existed is also market manipulation.
saharaaj
5 months ago
algos will meet the same fate as driver less cars on Indian roads wrong side traffic too high car server will crash with data
singhalpar100
5 months ago
The requirement now to be made by SEBI was earlier already implemented by Commodity Exchanges under FMC ( erstwhile regulator of Commodities derivatives ). Strange that some have objections to late move of SEBI now. This proves that people who are objecting are not well wishers of Investors.
singhalpar100
5 months ago
Excellent SEBI move and definitely it it in interest of Investors. The erstwhile regulator of Commodities already had the mandate that Exchange needs to approve Algo strategy and this was successfully implemented with no hue & cry. People who are finding fault now with SEBI requirements definitely have double standards
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