Capital market regulator Securities and Exchange Board of India
(Sebi) might soon issue a framework on algorithm (algo) trading for individual investors. Currently, there is no bar on retail investors
from using algorithms. However, lack of regulatory guidelines is preventing progress in this area. Advancement in technology and availability of high-speed data on the go has resulted in a lot of development on this front globally. An enabling framework by Sebi will help India catch up, say brokers.
What is algo trading?
Last October, Sebi issued a discussion paper titled ‘Strengthening of the Regulatory framework for Algorithmic Trading & Co-location.’ In the paper, algo trading
in simple words was defined as “a step-by-step instruction for trading actions taken by computers (automated systems). Typically, trading algorithms enable the traders to automate the process of taking trading decisions based on the preset rules/strategies.”
To illustrate this, an investor can create a programme to buy a stock, whenever it’s price-to-earnings multiple drops below 10 times or dividend yield rises to five per cent. A trader can create an algo to sell a security whenever its price falls below 200-day moving average. These are a few simple examples. A trader or an investor can develop algos with more sophisticated strategies.
Does Sebi allow use of algo trading?
Sebi does allow the use of algo trading
in the domestic market. However, at present, it is mostly the institutional investors or proprietary brokers who extensively use algo. “Right now although algo trading
is available for all, for retail, it is a grey area. There are no broad or structured guidelines in place for retail participation. That’s why it is important that the guidelines are issued,” says Prakarsh Gagdani, CEO, 5paisa.com
Also, popular among institutional investors and brokers is High-Frequency Trading (HFT), a subset of algo trading.
HFT uses technologies such as high-speed networks and collocation facility, in order to gain faster access to the exchange trading systems and capture trading opportunities that may be available for a few microseconds.
Buying or leasing the HFT infrastructure is a high-cost affair. Therefore, it is out of bounds for retail investors.
However, Sebi is mulling steps to blunt at least some advantage of those using HFT to provide a more equitable access to all participants.
What is the contribution of algo-trading to overall volumes?
As per Sebi data from a year ago, over 80 per cent of the orders placed are generated by algorithms. Such orders contribute to approximately 40 per cent of the trades on the exchanges. (Not all orders result in trades).
Lack of explicit guidelines from Sebi on what is allowed and what is not has prevented many brokers from providing algo trading
platforms to retail investors.
Some brokers have now started allowing retail investors
deal through algos.
Globally, it is popular for a broker to allow a so-called API
(Application Programming Interface)-linkage to their trading system. API
is an interface that allows one software programme to interact with other software.
So, at one end, there is an algo devised by a retail client, which is allowed to connect to the trading software or website of the broker.
Due to lack of an enabling provision, currently, an investor has to manually punch the order. For example, an investor will run a query on an excel sheet, to filter stocks that are available at the P/E of, say 10 or less. He will then log on to the broker’s terminal or website and manually buy these shares. Often the trading strategies are so dynamic, that it is impossible to execute them manually and therefore you need algo systems. Industry players, say API-linking—it is also called as ‘execution algo’— has become very popular globally, which has enabled a lot of tech-savvy investors to deal through algo.
Domestically, India lags behind on this front. “If a retail investor wants to use algo trading
by linking his API
to a broker terminal, the requisite platform is not available. Whether or not this is allowed is a grey area,” says Gagdani.
Why is the framework needed from Sebi?
“A lot of guys now understand technology easily. They have their own algos and strategies; they just need their proper infrastructure to execute orders. Therefore, it will good if Sebi comes out with the framework,” says Gagdani.
Industry players say while Sebi has broad guidelines in place, it should issue a framework for retail-focused brokers. This would include whether or not API-linkage is allowed; also which are the stocks and segments can investors can deal in using algo. Also, what are the additional checks and balances required for both investors and brokers wanting to deal in algo.
Preventing misuse of algo
Brokers say Sebi should bar “use of algo as a commodity”. Once algos start becoming popular with the retail investors, there is a fear that programmers could start marketing algos with “guaranteed returns”. This could draw gullible investors and pose risk to the market. Industry players say Sebi should prevent algos or service providers from selling algo programmes that promise investors sure-shot returns.