Algo Trading

The SEBI proposes significant changes to its framework governing algo trading. Algo trading (algorithmic trading) refers to any trading activity that automates trades, and does not require manual intervention to place any orders, or monitor prices.

Algo trading is carried out in two ways. In straightforward method, the algorithms provided by the broker are used. The second route is that of API — application programme interface. This is the connection of electronic systems. It is like a data pipe which carries the algorithm. APIs enable the transmission of information. Consequently, a third party can create a code that will execute itself on the brokers platform. In the context of algo trading, third parties provide their algo on say, platform X which is connected to broker’s platform through an API. Thus, orders placed by the client on platform X get passed on to the broker. A broker can identify that an order is coming through an API and it cannot verify that it is an algo order.

In 2021, SEBI proposed to treat all API orders as algo orders. That has been scrapped. SEBI has now suggested with respect to API orders that an order per second (OPS) threshold be specified. All API orders above such threshold would be treated as algo orders.

SEBI has also suggested that algo providers or APIs should be brought within the regulatory ambit. These would be agents of stockbrokers who will register with the stock exchange and get their algos approved by the exchange. Thus, these will be accountable to customers as far as grievances are concerned. The clients will have the redressal mechanism deployed by SEBI.

The algos are classified into two categories — white box algos and black box algos. White box algos (execution algôs) execute orders based on fully transparent algorithms. The logic, decision-making processes and the rules are accessible, understandable and replicable. Black box algos are those whose logic is not known to the user and are not replicable. To provide black box algos, one would be required to register as a research analyst. For each algo, a research report would have to be maintained. If there is any change in algo logic, it would have to be registered afresh, together with a new report.

Stock exchanges will have to define the roles and responsibilities of brokers and the vendors on panel. A turnaround time must be specified for registration of algos. There would be post-trade monitoring by exchanges and there would be SOP for algo testing. A killer switch can shut down the malfunctioning algos. Broker supervision is necessary to assess their ability to distinguish between algo and non-algo orders. There would be risk management for API orders. SEBI has granted approval for a ‘Past Risk and Return Verification Agency (PaRRVA).

In future algos may be designed by AI. The arising risks must be envisaged.

It is natural that regulation of algos or AI-based algos will create some bureaucracy. Still, the regulator must have a grip on something that can have systemic impact on the markets.