Mint Explainer: Understanding Sebi’s new framework on algo trading

However, with growing demand from retail investors, the Securities and Exchange Board of India (Sebi) has introduced a framework to allow retail investors to participate in algo trading safely.

Mint provides an overview of what this regulatory move means for retail investors and what steps are being taken to prevent potential risks such as market disruptions or unauthorized trades.

What is algo trading?

Algorithmic trading refers to the use of computer algorithms (automated trading systems) that can process large amounts of data and execute orders in fractions of a second. It offers several advantages like improved speed, reduced transaction costs, and better liquidity, making it an attractive option for investors.

Currently, institutions can use direct market access to trade using algorithms. Sebi’s circular on 4 February extended these benefits to retail investors by introducing a comprehensive regulatory framework that ensures the safety and integrity of the market.

Retail investors will be allowed to participate in algorithmic trading, but only through registered brokers who must obtain exchange permission for each algo strategy. 

Investors may have to pay subscription fees for using third-party algorithm services from fintech providers and additional cost may include the hardware, software, and reliable internet connectivity to ensure smooth operations.

As for brokers, experts believe this move may involve application fees and administrative costs for approval from exchanges.

“Brokers will need to invest in advanced technology and infrastructure to ensure compliance with Sebi’s regulatory guidelines and additional staffing and resources will be required to monitor APIs,” said Ashish Padiyar, managing partner, Bellwether Associates LLP.

Role of brokers

Brokers will be the gatekeepers, facilitating retail investors’ access to algorithmic trading through application programming interfaces (APIs). They will ensure compliance with regulations, monitor trades, and manage risks.

All algo orders will be tagged with a unique identifier provided by stock exchanges to ensure transparency and maintain an audit trail.

They will ensure that API access is secure by implementing two-factor authentication and using static IPs. Only authorized algo providers will be allowed access to the broker’s API.

They will also be responsible for resolving investor complaints related to algo trading.

Also Read: What’s Sebi’s score: Increasing investor complaints test regulator’s redressal system

Role of algo providers 

Algo providers (companies or fintech firms that create and provide algo trading solutions) must be empanelled with stock exchanges. Brokers are required to conduct due diligence before onboarding these providers.

Algos that retail investors develop themselves must be registered with exchanges if they exceed certain thresholds in terms of orders per second. These registered algos can be used by retail investors for their immediate family (spouse, dependent children, and dependent parents). 

Experts said that this could carry substantial risks. Kailash Lad, partner at Little & Co said software glitches could cause errors in trades, leading to potential financial losses, while delays in order execution, especially during volatile market conditions, could result in missed opportunities or unintended trades.

“Using unregulated platforms leaves investors vulnerable to fraud and limits access to dispute resolution mechanisms. Managing one’s own algorithmic strategy can induce emotional stress, leading to hasty or irrational decision-making”, he added. 

Meanwhile, exchanges will oversee the functioning of algo trades, ensuring that market disruptions are prevented. This includes having the ability to trigger a “kill switch” to halt malfunctioning algos.

Also Read: Sebi takes its investor-protection crusade to algo trading turf

White-box and black-box algos

White-box algos (execution algos) are transparent and replicable algorithms. Retail investors can freely use them, provided they meet the necessary requirements and are registered with brokers and exchanges.

Black-box algos are proprietary systems where the underlying logic is not disclosed. The providers of such algos will need to register as research analysts with exchanges and submit detailed research reports for each algo they offer.

Lad said the categorization of algorithms into ‘execution’ and ‘black box’ impacts retail investors by increasing transparency. “Execution algos or white box allows investors to modify strategies based on market conditions, providing greater control. Meanwhile, black box offers less flexibility since their internal logic cannot be altered,” he explained.

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Implementation timeline and potential risks

The industry standards forum for brokers under the aegis of stock exchanges will finalize the implementation standards by 1 April. The provisions of the new framework will come into effect from 1 August.

Experts believe that this framework enables retail investors to engage in algo trading under strict oversight, enhancing market efficiency and liquidity. “Increased automation may influence traditional trading strategies, accelerating the adoption of algorithmic methods,” Lad said.

The framework introduced safeguards to ensure controlled participation by retail investors in algo trading, which experts said could improve liquidity through higher regulated trading volumes.

“With brokers required to pre-approve and monitor all retail algo strategies, only compliant and well-tested strategies will be deployed, promoting stable liquidity without excessive speculative trading. The tagging and tracking of algo orders will improve order flow visibility, leading to more predictable liquidity conditions,” Lad said.

However, also-driven trades could also lead to sharp market fluctuations, and poorly designed algos may be vulnerable to cyber threats, experts warned. 

“Over-reliance on automation may not account for unforeseen market conditions, potentially resulting in unfavorable outcomes,” Padiyar said.

He said while an increase in market liquidity will enable more competition, it could raise concerns about potential market volatility due to inexperienced participants employing complex trading strategies. 

“It may also lead to heightened volatility, especially if algorithms react similarly to market events. Regulations are designed to ensure that the growth in algo trading is accompanied by appropriate safeguards to maintain market stability. How well it works, time will tell,” Padiyar said.

Also Read: What’s Sebi’s score: Increasing investor complaints test regulator’s redressal system