Regulating Algo Trading

Regulating Algo Trading

Algorithmic trading, or algo trading, refers to automated buying and selling of securities at lightning speed, using advanced analytical models. In December 2021, the Securities and Exchange Board of India (SEBI) drafted its first set of detailed proposals outlining how it planned to regulate the growth of algo trading in Indian markets, particularly for retail investors. This development came on the heels of concerns raised by brokerages and a research paper published by the Indian Institute of Technology, Madras, which highlighted the dangers posed by the lack of regulations on algo trading, to human traders and retail investors.

Confused by what the fuss is all about? Let us break it down for you.

What exactly is algorithmic trading?

Algo trading is a fascinating bit of financial innovation that’s seen tremendous growth over the last four decades- in quite the same manner and timing as the mobile revolution and social network acceleration. At its core, algorithmic trading is trading that’s executed by automated programs which monitor stocks based on certain variables or criteria that a trader might care about. Its popularity among retail and institutional investors has grown globally over the last decade and it has recently hit Indian stock markets’ shores. Algo trading now accounts for significant chunks of trading in several markets- as of 2019, it accounted for 92% of forex market trading. Consequently, understanding this phenomenon in a bit more detail could be pretty useful.

What makes algo trading so lucrative is, the hard work of monitoring stock parameters and trying to respond within seconds to fresh developments and new information, gets much easier for human traders. The work to gain a reliably profitable first-mover advantage is done by computer programs, in the blink of an eye. The algorithms communicate almost instantaneously with stock exchanges using digital interfaces. This forms the basis of several cutting-edge investment strategies and modeling, including the much-talked-about strategy of “high-frequency trading,” which executes transactions several times within a second.

So what’s the problem here?

As with any technological innovation, there are concerns about what this kind of automation could imply for investors, particularly the small retail investors. Let’s look at two of the most immediate problems to understand these concerns.

First, algo traders generally place huge volumes of orders and cancel them (or sell them) within a matter of seconds. The short term spike in share price offers a window for profit that could be as small as a couple hundred microseconds - less than the time you’d take to blink your eyes. The size of these orders, coupled with their turnover rates, generally means that these trading mechanisms can change stock prices incredibly quickly, before human eyes can even process what happened in the first place. All this happens at a very granular level of accuracy, making it efficient, but it could also result in a widespread reduction in liquidity. Liquidity, in simple terms, is the ability to buy and sell an asset without drastically affecting its market price. When algo traders make such quick changes and cancel their orders, human traders get crowded out. This reduces the level of liquidity in markets, and puts human traders at a disadvantage. That leads us to the second problem, which sharply hits human traders.

The fact that algo trading is so much more efficient than human judgment can put retail investors at a tangible disadvantage. This has resulted in algo trading becoming much more popular for a wide variety of retail and institutional investors. However, given the level of complexity of algo trading, it still remains out of bounds for small scale, non-tech savvy investors. This throws the doors wide open to retail investors falling prey to misleading claims by algo traders who are not sufficiently honest about the several risks of algo strategies. These retail investors could experience enormous losses without even understanding what algo trading is all about.

“Well, that’s unfortunate, of course,” you may say, “but trading always carries risks, so why does this matter?” The answer is simple: the interests of uninitiated and vulnerable investors need to be safeguarded. In the past, it was impossible to determine whether a trade made online came from an algo trader or a non-algo trader using a third-party service. This opacity means that, effectively, retail investors who operate through a third-party algo service have no grievance redressal mechanism, and consequently, stand a chance to get defrauded (which is why regulation generally exists in the first place).

Destination: Regulation

These concerns proved enough motivation for SEBI to propose a set of regulations to this end. In December, they published recommendations that, fundamentally, do some very simple but powerful things.

The framework they put in place states that all orders flowing into market systems through digital interfaces, will be treated as orders placed by algo traders and must be controlled by stockbrokers. It also provides a way to vet algo traders by making them submit to an approval process, upon which they will be certified with their own unique algo ID (almost like an algo Aadhaar) if they pass the conditions that SEBI will lay down. Furthermore, SEBI now mandates that brokers keep strict tabs on what goes into the algorithms, making sure that they aren’t changed on the fly without proper authorization. All these changes serve to strengthen this type of trading for human investors, making it more robust and accountable. However, there will be some changes where existing algo traders, brokers, and other related third-party algo service providers are concerned.

Effects, in a nutshell

This framework exists to make algo trading more reliable and trustworthy as a way to earn returns. Let’s break down the implications it could have on some stakeholder groups.

For brokers:

  • This would enable brokerage houses to capitalize on retail investors’ enhanced trust in algo trading.
  • Brokerages will now be able to expand their client base to include more retail investors, who will now be covered by a set of protective regulations - just like institutional investors, while also making sure that their algorithms are resilient and potent.
  • All in all, this will be an exciting development from their perspective, and the hope is that it will help democratize algo trading for the customized needs of a diverse group of retail investors.

For retail investors:

  • The benefits of this regulatory framework to retail investors are clear- unsurprising, given that these proposals were framed with the express purpose of protecting their interests.
  • It establishes ground rules to help retail investors take advantage of these marvelous innovations while protecting their interests against unscrupulous activity (reducing the level of losses they may face) and price manipulation that might otherwise harm them.

For third-party algo service providers:

  • Third-party algo service providers will still be able to provide their services post the implementation of the proposed reforms.
  • However, the regulations will force them to comply with an enhanced set of norms surrounding disclosure and transparency with their clients- a heterogeneous group of both amateur traders and informed experts.
  • This will likely result in certain unscrupulous third-party providers either cleaning up their act and being honest with their clients, or facing penalties for breaking the law.

For currently operating algo traders:

  • Currently operating algo traders are unlikely to face insurmountable difficulties with the new set of regulations.
  • The framework is really a measure intended to rein in third-party providers who might not be upfront with their retail clientele about investment strategies and risks.
  • That said, the short-term challenge for currently operating algo traders will be to go through SEBI’s new regulatory system to be approved as an algo trader.
  • In the long run, it is unlikely to have much of a detrimental effect on currently operating traders who work within the boundaries of the law.

What’s the flipside?

As is the case with any financial regulation, there are worries that this might result in reduced innovation and curtailed algorithmic trading- which could be detrimental to equity markets like ours. Around 50% of all trades in India are conducted through algorithmic trading (which is lower than the figure of 80% worldwide, meaning there is room for it to grow). Would this regulation set us back?

Probably not. To be sure, there will almost certainly be a temporary impact on algo trading as firms navigate their ways through the new approvals systems that will be set up to delineate algo trading firms, and classify them in different categories, as is the norm in several Western markets. However, once these approvals are all consolidated, we should see a significant increase in the adoption of algo trading by many retail investors and brokerages, which bodes well for the health of future innovation. Effective regulation to provide an adequate redressal mechanism without stymying innovation will be pivotal in this process.

In conclusion…

Algo trading has seen stunning growth and ever-increasing significance in our digital age, and portends revolutions in market efficiency and the price discovery mechanism. However, well-crafted legislation is necessary to ensure that some guardrails and basic norms are added that protect investors’ interests without stifling innovation and growth.

This is what the SEBI regulatory framework of December 2021 sets out to do. We at Liquide can’t wait to see how this story plays out, as we chart our investment journeys with you, and we look forward to what we hope will be a groundbreaking era of continuous improvement in this ingenious domain of the future!