Greenvissage explains, How is SEBI making Algorithmic Trading Safer?
The rise of retail investors in the Indian stock market has been accompanied by a surge in the popularity of algorithmic trading (or simply, algo trading). To address the growing participation of retail investors in this area and the associated risks, the Securities and Exchange Board of India (SEBI) has rolled out a new regulatory framework. This initiative aims to make algo trading more accessible, transparent, and safer for individual investors while ensuring the integrity of the financial markets. Algorithmic trading refers to the use of computer algorithms or automated systems to execute trading orders based on specific pre-set conditions. For example, an algorithm might automatically buy shares when their price exceeds a particular threshold and sell them once the price falls below a certain level. This automation enables traders to react to market movements without needing to monitor the markets constantly. It also helps reduce the impact of human emotions on trading decisions, such as fear or greed. In India, algo trading accounts for approximately 70% of the total market volume, with institutional investors dominating this space. However, the rapid rise of retail participation in the stock market has led many individual investors to explore the potential of algorithmic trading. While algo trading offers various advantages, such as increased speed and objectivity, it also poses certain risks if not used responsibly.
As the popularity of algo trading grows, SEBI has observed an increase in unregulated platforms offering algorithmic trading strategies with promises of unrealistic returns. These platforms have created concerns about the safety of retail investors, prompting SEBI to introduce new measures aimed at safeguarding their interests. A key aspect of SEBI’s new framework is the requirement for brokers to seek approval from stock exchanges for each algorithm they deploy. Every approved algorithm will be assigned a unique identification number (ID) for better tracking and auditing, ensuring that any technical glitches or violations can be quickly identified and corrected.
SEBI has introduced two broad categories of algorithms: White Box Algos and Black Box Algos. White Box algorithms are fully transparent, allowing users to understand and even replicate the underlying logic of the system. On the other hand, Black Box algorithms, which are commonly used by institutional traders, are proprietary and less transparent. These will face stricter regulatory measures, including the requirement for algo providers to register as research analysts and maintain detailed records of their operations. One of the most significant changes under the new framework is the requirement for retail investors to register their algorithms with exchanges via their brokers. This registration process ensures that retail traders adhere to the same risk management rules as those used by brokers and institutions. The goal is to prevent disruptions to the market caused by poorly designed or malfunctioning algorithms. Another major part of SEBI’s framework is the introduction of stronger security features for brokers offering Application Programming Interface (API) services. APIs allow traders to connect their algorithms to the stock market for automated execution. To minimize the risk of unauthorized access, brokers are now required to implement two-factor authentication and other access controls to ensure that only authorized users can access and use the APIs. In addition, stock exchanges will have the authority to intervene in cases of malfunctioning algorithms. They will be able to halt any algorithm that poses a risk to market stability using a ‘kill switch.’ This feature is crucial to preventing significant disruptions or losses caused by erroneous trades.
References:
- SEBI – Circular on Participation of Retail Investors in Algorithmic Trading
- Investopedia – Basics of Algorithmic Trading: Concepts and Examples
- Economic Times – Sebi opens algorithmic trading to retail investors: Opportunities, risks, and the future of HFT in India
- Indian Express – SEBI proposes allowing retail participation in algo trading
- Image by pch.vector on Freepik
