EXCLUSIVE: SEBI reviewing regulations for algo trading?

Amid concerns about unregulated and unapproved algorithms—popularly known as algos, capital market regulator SEBI is considering the overhauling of regulations. Algos are trades generated using pre-defined automated execution logic that is based on historical data. SEBI is of the view that such uncontrolled algos pose a risk to the market, can be misused for market manipulation, and can lure retail investors by guaranteeing them higher returns, according to sources. The potential loss in case of a failed algo strategy can have a huge impact on retail investors. As third-party algo providers or vendors are unregulated, there is also no investor grievance redressal mechanism in place. 

What is the plan for algo regulation?

Risk management system for retail algos

Brokers must do due diligence and risk profiling of retail clients, such as education, net worth income, etc. For safeguarding purposes, all the registered strategies must have predefined caps on quantity and value order-wise, day-wise and client-wise. Beyond these limits, the strategy will automatically not work. Also, algo strategies will not be used for illiquid contracts. There will also be restrictions on the number of times an order can be modified. Brokers will have to ensure that prices quoted by orders do not violate price bands announced by exchanges. Systems to detect algo strategy malfunction and requisite surveillance may also be incorporated into regulations. Brokers will also be expected to develop a monitoring system to identify similar kinds of orders coming from different clients which can be construed as a potential assured return scheme. Brokers will not be allowed to place algo orders on behalf of clients. A throttle rate not exceeding 30 orders per second should be mandatory for execution. Malfunction and complaints due to malfunction should be reported to the exchange.   

Control on API

A SEBI-constituted working group has submitted its report on the matter and discussions are on to implement the measures suggested by it. The major recommendations include control of the application programming interface (API). The working group has suggested that all algo providers and vendors of fintech companies have to be empanelled with the exchange. Also, they should be registered with the broker so that brokers can supervise them as they do with authorised persons. The suggestion is brokers have to ensure that they deal with exchange empanelled vendors only or develop in-house capability. Currently, many algo providers are neither registered with a broker nor empanelled with the exchange. SEBI wants all algo IDs to be registered with the exchange and brokers should not allow open API access. 

Strategies used by the API model should be known to the broker

It is being discussed that all the algo strategies should be registered with the broker and brokers need to ensure that all such strategies should be registered with the exchange. Brokers can allow such strategies only after algos are registered with the exchange. Any modification or change has to be approved by the exchange. Black box algos should be provided by SEBI-registered entities only and all algo orders should be tagged with an exchange-issued algo ID. Brokers must ensure that no unauthorised tweaking or alteration is possible in algos. Algo should be certified by CISA/DISA. Brokers will have to ensure that authorised vendors, fin-tech companies, and algo makers use their names as part of testimonials. The working group also suggested that the broker must have the capability to ensure risk control checks at the individual order level and client level order before each order generated by algo is released to the trading system. In the algo orders, the exchange prescribed daily price limit, maximum order size threshold, and position limit should not be breached.

Role of Exchanges

Exchanges will have to form rules to register the algo providers, algo vendors, or fin-techs, converting aspects such as defining criteria, roles, and responsibilities of brokers and algo providers. Exchanges will also have to do the post-trade monitoring of algo orders and trades. The exchanges will also be responsible for handling client complaints.  

Confidentiality of client data and due diligence

It is suggested that brokers continue to be responsible for the confidentiality of client-sensitive data as well as the orders flowing through APIs. Brokers will also have to abide by any law, or rule related to digital personal data protection. Regular vendor due diligence will also be a part of regulation.

SEBI plans to review the algo trading regulations emanating from the rising trend of usage by retail clients and the marketing of such strategies as a guaranteed return. Brokers were promoting API access to their clients, which enables investors to build their own front-end features or use a third-party application that suits their feature needs, covering aspects such as analysing market data or back-testing a trading strategy. Another concern raised by brokers is that they can identify the orders emanating from an API but unable to differentiate between an algo and non-algo order emanating from such API.

Recently, SEBI issued show cause notices to more than 120 stockbrokers for their association with the algo trading platforms despite being warned to disassociate.  

Zee Business's email to SEBI, seeking a response, remained unanswered at the time of publishing this report.