On Algorithmic trading/Algos: Regulate, don’t stifle

News: In a consultation paper last week, the Securities and Exchange Board of India (SEBI) proposed regulating retail or third-party algorithmic trading (algos).

What is algorithmic trading/Algos?

Algos are programmes that automatically monitor price-volume action and make trades without human intervention, buying and selling when pre-set instructions are triggered by price moves.

By the National Stock Exchange’s estimate, about 14% of the trading volume (and around 45 per cent of the trading value) is algo-driven.

What are the risks involved in algorithmic trading/ Algos?

Algos can place the user at greater risk. This is partly due to the lack of human intervention, and partly because they can be programmed to make simultaneous trades of different markets. It could spiral into a huge market-wide risk owing to lack of circuit filters.

The famous “Black Monday” crash of Wall Street on October 19, 1987, occurred because algos sold heavily without human intervention.

Why SEBI wants to regulate retail or third-party algorithmic trading?

Firstly, the regulator believes these modes of trading are risky and there is little understanding of how they function.

Secondly, it can be misused for systematic market manipulation as well as to lure the retail investors by guaranteeing them higher returns

Thirdly, the potential loss from a failed algo strategy may be huge.

What are the proposed regulatory changes?

SEBI has proposed to treat all orders based on the Application Programming Interface (API) as algo-driven. Further, such orders should be tagged with an ID unique to the brokerage.

Brokers should perform a sequence of stringent checks on any API-based trades to ascertain if these are algos.

It has also stated 3rd-party algo providers could be treated as investment advisors and that two-factor authentication (which implies human intervention) be put in place.

What are the issues in the proposed regulatory changes?

– It would impact retail traders and brokerages in terms of the cost of compliance.

It would retard the use of API-based technology, which smoothens trading processes for all investors.

SEBI already has many robust checks in place to ensure adequate margins are collected. It has circuit filters to halt trading if there is an extreme price move.

Note: Circuit filters are price bands imposed by the SEBI to restrict the movement of stock prices (up or down), of listed securities. When the stock price breaches a stipulated price band as decided by stock exchanges, trading in that particular stock is suspended.
What is the way forward?

Major retail brokerages estimate around one in 2,000 clients uses algos. This can be tackled by adequate margining.

Imposing high costs of compliance under the assumption that every API user is an algo trader would punish every investor.

Source: This post is based on the article “Regulate, don’t stifle” published in Business Standard on 15th Dec 2021.

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