Sebi paper on algo trading unnerves brokers. A protective net or regressive step? Jury’s still out. – The Economic Times

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SynopsisThe consultation paper proposes regulating algo trading with the intention to curb mis-selling, reduce probability of Black Swan events, and even frontrunning by brokers. However, traders believe that in an effort to protect retail investors, the regulator may simply bring in more clauses which will take the stock markets backward by a decade.

Fear has gripped the trader fraternity of the Indian equity markets. The trigger is the Securities and Exchange Board of India’s (Sebi) consultation paper on regulating algorithmic or algo trading. The paper raises questions on how algo trading is sold to inexperienced investors. The old guards are anxious that the regulator may throw the algo baby out with the bathwater – instead of going after the rogue ones, it may ban algo trading altogether.

Traders feel Sebi is bringing back the memories of license raj where retail investors will have to pay a heavy price to trade stocks. Hence, they seek more clarity on the issue. In fact, on December 9, when the consultation paper was released, a Twitter Spaces on the same topic gathered around 1,500 listeners to understand the issue at 10 pm.

Algo trading is not everybody’s cup of tea. Brokers themselves understand that it is a tool for sophisticated traders. However, at the same time one has to be careful with it. This is because today’s financial markets run on cutting-edge technology that are getting democratised everyday.

In simple terms, algorithmic trading means executing buy and sell orders in the stock market using pre-programmed computer strategies that use predefined rules for trading at micro-second intervals.

New and young traders are tech-savvy and comfortable using algos. In fact, the use of algo trading is steadily going up over the last few years. Algo trading, in general, is at 10%-13% of the overall market turnover. When the market crashed in March 2020, this number went up to almost 25% (on the day of the crash). This could have happened due to a contagion effect where algos may have gone into a downward spiral. While this is just a wild theory, Sebi is worried about these issues which can be termed as Black Swan events and can lead to more market falls driven by rogue algos.

However, traders believe Black Swan events are true to their name — they can’t be stopped no matter what steps the regulator takes. They feel that in an effort to protect retail investors from market crashes, the regulator might simply bring in stricter clauses, which will take the equity markets backward by a decade.

Algo trades as a % of total trades@2x

The backlash
Nithin Kamath, CEO of India’s biggest brokerage firm Zerodha, believes Sebi’s move would mean brokers will have to stop offering application programming interfaces (APIs).

“This will be two steps back in a tech-first future,” he tweeted.

Kamath expresses concern on the paper’s suggestion of categorising every order placed by an API as an algo order. He feels this will force the broker to get exchange approvals for any algo and calls it an extremely tedious and complex process for any customer using APIs.

“While customers using APIs today is a very small percentage of the business (0.05% of our business), disallowing will mean our capital markets taking two steps backwards in a technology-first world. Disallowing APIs will also not solve the problem of unregulated algo-trading platforms. They will just shift from using broker APIs to third-party automation tools which aren’t in the control of the brokers,” he warned in a blog on Zerodha website.

“The only way to solve this problem is by regulating these algo platforms and bringing them under the RIA/RA (registered investment advisor / research analyst) framework, which will put restrictions on the way some of these platforms are currently mis-selling algos as almost an easy and guaranteed way of making money, which isn’t true,” he added.

Vishal Mehta, an algo trader, agrees with Kamath. He too feels that asking the algo providers to register as RIA/RA would be the right thing to do. He warns that tougher measures could kill profits for many retail traders who have benefitted from the algo-trading boom over the last few years.

“Sebi’s primary goal is to stop mis-selling of fancy algos where they promise a certain percentage of returns. The second issue they want to address is of systemic risks if a badly designed algo shoots up.”

— Sandeep Parekh, managing partner, Finsec Law AdvisorsIt is only in the last few years that brokerages have started offering algo-trading solutions to retail investors, giving them a similar edge that was so far experienced only by institutional investors. To add to that, a booming stock market has ensured that many of them have tasted delicious profits in recent times. The demographics of the Indian stock market investor is fast shifting, with a high interest in trading and investing from those in their 20s and 30s.

The FOMO, or the fear of missing out, has also ensured that newly inducted traders are trying to resort to technical analysis and algo trading to rake in profits. Albeit, they have to be in agreement with the risk they are taking.

Mehta also flagged concerns that Sebi is asking for algos to be approved, and this would mean revealing their well-devised strategies to the broker and the exchange, and in that sense making it public.

“The broker can actually trade with us or maybe front-run us or trade against us too. That is the risk we need to be mindful of,” says Mehta.

That said, he agrees that regulation was the need of the hour but feels it could be planned better. “Put us under the RA/RIA category and ask us to seek a licence. As RAs and RIAs, we can get disclaimers signed by clients. When a trader opts for algo, he/she has to be mindful of the risk involved in trading,” says Mehta.

Will Sebi ban algo trading? On the face of it, it doesn’t look like that. It is merely trying to regulate algo trading. While near-term hiccups and pressure on certain players to survive aren’t ruled out, the regulator’s intent seems to be more towards protecting the retail investor. It is trying to curb mis-selling, reduce the probability of Black Swan events, and even front-running by brokers.

What Sebi’s proposal says
Sebi is proposing that brokers must take approval of all algos from the exchange. Each algo strategy, whether used by broker or client, must be approved and as is the current practice, each algo strategy has to be certified by Certified Information Systems Auditor (CISA)/ Diploma in Information System Audit (DISA) auditors.

The market regulator also wants all orders emanating from an API to be treated as an algo order and be subject to control by the broker. It proposes APIs to carry out algo trading tagged with the unique ID provided by the stock exchange granting an approval. It wants stock exchanges to develop a system to ensure that only those approved algos, with unique IDs, are being deployed.

A lot of responsibility is put on brokers, which isn’t going well with them. Sebi wants brokerages to deploy technological tools to ensure that appropriate checks are in place to prevent unauthorised altering/tweaking of algos. Brokers can either provide in-house algo strategies developed by an approved vendor or outsource the services of third-party algo provider/vendor by entering into a formal agreement with each third-party algo provider/vendor whose services are being availed by the broker.

The broker will also be responsible for all algos emanating from its APIs, and for assessing suitability of investors prior to offering algo facility. The brokers will also have to include a specific report on algorithm checks implemented by them as a part of the annual system audit report submitted to the exchanges.

Too much brouhaha?
While there has been a lot of heated debate over Sebi’s consultation paper, many believe it is probably a step in the right direction.

“In my opinion, Sebi is trying to avoid retail investors getting lured to markets by unregulated products riding on top of stock-broking APIs,” says Pravin Jadhav, founder and CEO of stock-trading platform Dhan.

“In principle we are in alignment with the broad possible proposed framework shared by Sebi, it is very much doable. We will suggest excluding retail investors executing retail algos with a daily cap,” Jadhav writes in a blog on the company’s website.

Not everyone agrees though. Many like Zerodha’s Kamath believe the market regulator’s suggestions seem regressive at the very least.

However, Sebi intends to strike down the growing popularity of unregulated algo trading platforms that offer off-the-shelf automated trading systems (ATS). Many of these platforms also make false claims of guaranteed returns, and lure retail investors which is what Sebi is really worried about.

“Sebi’s primary goal is to stop mis-selling of fancy algos where they promise a certain percentage of returns. The second issue they want to address is of systemic risks if a badly designed algo shoots up,” says Sandeep Parekh, managing partner, Finsec Law Advisors.

“However, the way Sebi has proposed it, brokers’ necks will be on the line. Anything comes through API, even if it is a poorly designed algo, the broker will be responsible. For something which is not even visible to them, they are not willing to take the responsibility. They will shut it down — that is the easier way out,” adds Parekh, who earlier served as an executive director of Sebi.

There has been a striking increase in the number of retail investors in the country ever since Covid-19 pandemic led to a lockdown, when economic uncertainty, work from home, along with a booming stock market attracted many. The number of investor accounts have risen 51% from 49 million at the end of March 2020 to 73.8 million at the end of November 2021.

This has also meant many lesser-informed investors storming the market and falling prey to dubious claims made by unregulated entities. This is also happening at a time when financial cyber frauds have surged, making such investors gullible.

Hoping for a middle path
For now, the broking and trading communities hope that Sebi will simplify or tone down its approach. While the motive is to protect retail investors, it should not mean a missed opportunity for those who understand the technology and are willing to take higher risks.

“Sebi is perhaps trying to prevent unauthorised fund managers, pseudo portfolio advisors from giving unqualified advice in the form of automated trading. There are offline advisories like the Indore tipsters for instance, that are now masquerading as algo-strategy experts,” says Tejas Khoday, co-founder and CEO of stock-broking platform FYERS.

“Algo trading is basically a rule-based approach to trading and solves a real-world problem as it helps traders manage risk more effectively. It also eliminates emotions from the decision-making process. All in all, algo trading is a net positive for the ecosystem. We hope the regulator takes a constructive stance and sees its long-term benefits,” he adds.

(Graphic by Sadhana Saxena)

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