Sebi may soon introduce framework on retail algo amid concerns of misuse

Regulator in touch with exchanges, set to accept proposals made in discussion paper

The Securities and Exchange Board of India (Sebi) may soon issue a framework on regulating algorithmic (algo) trading for retail investors amid concerns over manipulative practices, said people in the know.

The framework will be based on a discussion paper floated by the markets regulator in December despite pushback from the broking industry on certain recommendations — particularly the one around algo trades emanating from application programming interface (API).

Sources said Sebi and stock exchanges are working on a framework to authorise and approve algo strategies and provide each with a unique identification number to get a better handle on algos aimed at retail clients.  Further, the proposed framework also intends to put the onus on brokers when it comes to monitoring algo programmes used by their clients.

Likely to be introduced by Sebi soon, the algo framework will be based on proposals in the discussion paper floated last year.

“Since there is limited understanding with respect to the nature of services provided by various algo providers, brokers may obtain from their clients, details of the nature and type of services taken from algo providers, along with confirmation on whether the said services are in the nature of investment advisory services,” the paper had cited as one of the key reasons for proposing the framework.

People in the know said Sebi could also go ahead with the controversial proposal on treating all API-based trades as algo trades.

If approved, all API-based trading strategies will require pre-approvals from stock exchanges before brokers can allow them as plug-ins. This clause had faced opposition from the industry, which had urged the regulator to demarcate non-algo and algo APIs.

CHANGING ALGO

• All algo trades may require pre-authorisation 
• APIs, used for automated trades, to be treated as algos
• Brokers will have to up their monitoring, tracking changes to algo
• All algos will be required to obtain unique IDs
• Algo to use servers that will give brokers control over client orders
• New framework aimed at making algo trading safe and to prevent market manipulation

Sources said a study done by stock exchanges has shown that more than 90 per cent of orders generated using APIs are algo orders.

“Since a majority of API orders are algo-based, Sebi feels regulating them is a key. A few non-algo APIs will get impacted until the industry is able to find a solution to differentiate between the two,” said an official privy to the development.

An API is a software that allows two applications to communicate with each other. In recent years, third-party firms have developed APIs that can be linked to a trading application like that of Zerodha or HDFC Securities. Once installed, APIs get the authorisation to perform a host of functions in the trading account — such as placing buy-and-sell orders or cancelling orders.

Currently, neither Sebi nor exchanges have a direct handle on API-generated trades as they are executed at the broker level. As a result, there is no accurate data around its contribution to trading volumes. The data on API-based trades, however, is available at the level of individual brokers.

Some leading industry players said orders routed using APIs account for less than 10 per cent of their trading volumes, while overall algo orders could be between 20 per cent and 30 per cent.

Misuse of algo software has been a matter of concern for exchanges and the regulator for some time amid its growing adoption.

Earlier this month, Sebi issued a circular asking brokers to refrain from mentioning past returns or expected future returns and directed it to disassociate with any platforms who do so.

Many industry players see Sebi’s latest diktat as a precursor to a broader framework around dealing with algo trading, which is in the works for nearly a year.

Most industry players are on board with regulating algos, even though they fear a stricter regime might stifle innovation that is taking place in the API space.

“I only hope that the circular expected on the use of APIs and algos after the discussion paper from last year doesn’t obliterate or make it hard for retail customers with programming knowledge using APIs for personal use, becoming collateral damage,” said Nithin Kamath, founder and chief executive officer, Zerodha — India’s largest broker — in a recent tweet.