Sebi to put a leash on third-party algo providers, to build a new framework

The Securities and Exchange Board of India (Sebi) has proposed regulating third-party algorithmic, or algo, service providers, as the regulator said there is little understanding on how they function. Algo trades account for over 14 per cent trade in the cash market, according to data provided by the NSE. Although, market players say the number could be higher as a lot of algo-oriented trades are not fully captured. “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 nature and type of services taken from algo providers along with a confirmation as to whether the said services are in the nature of investment advisory services,” Sebi said in a discussion paper on Thursday. The markets regulator said such unregulated algos pose a risk to the market. And “can be misused for systematic market manipulation as well as to lure the retail investors by guaranteeing them higher returns”. The potential loss, it said, in case of a failed algo strategy is huge. The regulator said inputs received from brokers will help formulate a policy framework on third-party algo providers. In recent years, many third-party algo traders have mushroomed, who cater to both amateurs and experts.

These firms design a software that can be used as a plug-in or an extension into any broking application to enable algo trading.

This type of trading essentially relies on a pre-defined set of instructions that trigger a buy or sell order. The algo trading system automatically monitors live stock prices and initiates trades when the set criteria are met without any human intervention. There are several algo strategies that are deployed by traders. Some of the most common ones are those that capture price differences of the same scrip between two exchanges or between cash and derivatives markets. Such strategies are called arbitrage trading, which are now efficiently performed with pre-programmed software or automation. In the discussion paper issued on Thursday, Sebi also proposed several other checks and balances on algo trading, particularly done by retail investors. “All orders emanating from an API should be treated as an algo order and be subject to control by stock broker and the APIs to carry out Algo trading should be tagged with the unique algo ID provided by the Stock Exchange granting approval for the algo,” Sebi has proposed. API or application programming interface is a software that allows two applications to talk to each other—in this case the algo and the trading application. “Stock exchanges have to develop a system to ensure that only those algos which are approved by the exchange and having unique algo ID provided by the exchange are being deployed. Brokers shall also deploy suitable technological tools to ensure that appropriate checks are in place to prevent unauthorised altering/tweaking of algos,” Sebi has said. Also, brokers will deploy suitable technological tools to ensure that appropriate checks are in place to prevent unauthorised altering or tweaking of algos. They need to have adequate checks in place so that the algo performs in a controlled manner. All algos developed by any entity have to run on the servers of brokers wherein the broker has control of client orders, order confirmations, margin information among others. Sebi suggested that brokers can either provide in-house algo strategies developed by an approved vendor or outsource the services of a third party algo provider/vendor. The regulator said that obligations of the stock broker, investor, and third-party algo provider need to be separately defined. The regulator proposed that two-factor authentication should be built into every such system that provides access to an investor for any API/algo trade. The Sebi has sought comments from the public till January 15.

Eye on algo

Mode of trading	Share (%)*
Non Algo	18.89
Algo	14.43
Direct Market Access (DMA)	2.16
Colocation	35
Internet Based Trading (IBT)	11.96
Mobile	16.53
Smart Order Routing	1.03

Source: NSE: Note: Data for November 2021; Share in cash market turnover