Explained: Why SEBI wants to regulate private algo service providers

The country’s stock market regulator is moving to check unregulated algorithm service providers and their use by retail investors.

The Securities and Exchange Board of India (SEBI) said in a consultation paper released on Thursday that its move to regulate the private algo service providers was important as the customers have no understanding of how they actually work.

So, how significant are these algo trades as far as India’s capital markets go?

Citing data provided by the National Stock Exchange, a report by the Business Standard newspaper said that algo trades account for over 14% in the cash market. But the report added that traders privately say the market could be much bigger.

What has SEBI actually said in its discussion paper?

“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.

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.

How do private algo trading firms actually work?

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

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, the newspaper report added.

So, how does SEBI want to check such private trades?

In its discussion paper, SEBI has said that all orders emanating from an API (application program interface) 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.

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 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.