Algo trading: How Sebi's new rules can help avoid risks, frauds, offer level playing field
According to the new guidelines, brokers will be permitted to provide algo trading services only after receiving approval from the stock exchange for each algorithm.
- Dec 28, 2024,
- Updated Dec 28, 2024 1:32 PM IST
The Securities and Exchange Board of India (SEBI) has recently propsed a regulatory framework to facilitate the involvement of retail investors in algorithmic trading. This framework defines the duties of both stock brokers and exchanges and proposes the classification of algorithms into two categories.
According to the new guidelines, brokers will be permitted to provide algo trading services only after receiving approval from the stock exchange for each algorithm. Moreover, all algorithm orders must be labeled with a unique identifier assigned by the exchange to maintain a transparent audit trail.
Algo trading entails utilising computer programs to invest at a faster rate and more efficiently than a human counterpart, with minimal intervention. These programs connect to broker platforms via an API. Like any trader, a program can incur losses if the underlying strategy is flawed or fails to adapt to market conditions.
Although algorithmic trading presents numerous technological obstacles, many inexperienced retail investors are lured by the idea of automated software that promises extraordinary returns.
In 2008, the SEBI introduced algorithmic trading to India through the Direct Market Access (DMA) Facility. Initially, this trading method was limited to institutional investors such as hedge funds, mutual funds, and proprietary trading firms.
Sebi is taking steps to regulate third-party algo trading providers who take advantage of investors looking for quick profits. The draft rules released on December 13 aim to provide clarity for these providers, who were previously operating in a regulatory grey area. This initiative is expected to support the growth of legitimate vendors in the industry while weeding out unscrupulous players
"In the recent 208th Sebi board meeting, regulator was approved a proposal to form a agency called Past Risk and Return Verification Agency (PaRRVA) to verify the past risk-return metrics of algorithmic trading, This agency will works under the credit rating agencies, and it is mandatory to verify for the institutions who facilities the algo trading and claim regarding their past risk-return metrics. However, it is voluntary for the institutions who does not wish to claim regarding their past risk-return metrics," said Feroze Azeez, Deputy CEO, Anand Rathi Wealth Limited.
He added: "In simple algo-trading is a system that automates the decision-making in the trading process like when to buy and sell based on the pre-determined metrics. Although algo trading comes with a fewer risks. Algo’s can compromised when their systemic failures, API errors, and market anomalies occur. Algo’s are mostly hands-free from investors, but investors need to intervene when there is market shocks or high volatility in the market and investors should solely not depends on the back-testing results of algo to predict the future potential. Investors must understand the how their algo works and thoroughly review the investment strategy prospects, risk metrics, potential losses/maximum drop-down’s and expected performance potential before investing. It is not recommended for risk-averse investors to opt for algo-trading."
Stock Exchanges
The proposed framework tasks stock exchanges with overseeing algorithmic trading. Exchanges must carry out post-trade monitoring of algorithmic orders and trades, as well as establish a Standard Operating Procedure (SOP) for testing algos. Additionally, they are required to delineate the roles and responsibilities of brokers and approved vendors.
This initiative is a response to the changing landscape of algo trading and the increasing interest from retail investors. Historically, algo trading has primarily catered to institutional investors. However, the regulator has recently taken action against multiple brokerages for maintaining relationships with algo providers who make unrealistic promises of returns. This scrutiny, along with crackdowns on major brokerages, may have motivated Sebi to introduce clear regulations, according to a source familiar with the discussions.
The stock market regulator has opened the floor for comments on the draft circular until January 03, 2025.
The Securities and Exchange Board of India (SEBI) has recently propsed a regulatory framework to facilitate the involvement of retail investors in algorithmic trading. This framework defines the duties of both stock brokers and exchanges and proposes the classification of algorithms into two categories.
According to the new guidelines, brokers will be permitted to provide algo trading services only after receiving approval from the stock exchange for each algorithm. Moreover, all algorithm orders must be labeled with a unique identifier assigned by the exchange to maintain a transparent audit trail.
Algo trading entails utilising computer programs to invest at a faster rate and more efficiently than a human counterpart, with minimal intervention. These programs connect to broker platforms via an API. Like any trader, a program can incur losses if the underlying strategy is flawed or fails to adapt to market conditions.
Although algorithmic trading presents numerous technological obstacles, many inexperienced retail investors are lured by the idea of automated software that promises extraordinary returns.
In 2008, the SEBI introduced algorithmic trading to India through the Direct Market Access (DMA) Facility. Initially, this trading method was limited to institutional investors such as hedge funds, mutual funds, and proprietary trading firms.
Sebi is taking steps to regulate third-party algo trading providers who take advantage of investors looking for quick profits. The draft rules released on December 13 aim to provide clarity for these providers, who were previously operating in a regulatory grey area. This initiative is expected to support the growth of legitimate vendors in the industry while weeding out unscrupulous players
"In the recent 208th Sebi board meeting, regulator was approved a proposal to form a agency called Past Risk and Return Verification Agency (PaRRVA) to verify the past risk-return metrics of algorithmic trading, This agency will works under the credit rating agencies, and it is mandatory to verify for the institutions who facilities the algo trading and claim regarding their past risk-return metrics. However, it is voluntary for the institutions who does not wish to claim regarding their past risk-return metrics," said Feroze Azeez, Deputy CEO, Anand Rathi Wealth Limited.
He added: "In simple algo-trading is a system that automates the decision-making in the trading process like when to buy and sell based on the pre-determined metrics. Although algo trading comes with a fewer risks. Algo’s can compromised when their systemic failures, API errors, and market anomalies occur. Algo’s are mostly hands-free from investors, but investors need to intervene when there is market shocks or high volatility in the market and investors should solely not depends on the back-testing results of algo to predict the future potential. Investors must understand the how their algo works and thoroughly review the investment strategy prospects, risk metrics, potential losses/maximum drop-down’s and expected performance potential before investing. It is not recommended for risk-averse investors to opt for algo-trading."
Stock Exchanges
The proposed framework tasks stock exchanges with overseeing algorithmic trading. Exchanges must carry out post-trade monitoring of algorithmic orders and trades, as well as establish a Standard Operating Procedure (SOP) for testing algos. Additionally, they are required to delineate the roles and responsibilities of brokers and approved vendors.
This initiative is a response to the changing landscape of algo trading and the increasing interest from retail investors. Historically, algo trading has primarily catered to institutional investors. However, the regulator has recently taken action against multiple brokerages for maintaining relationships with algo providers who make unrealistic promises of returns. This scrutiny, along with crackdowns on major brokerages, may have motivated Sebi to introduce clear regulations, according to a source familiar with the discussions.
The stock market regulator has opened the floor for comments on the draft circular until January 03, 2025.