Algorithmic Trading

Context:

Recently, the Securities and Exchange Board of India (SEBI) has issued a discussion paper on regulating Algorithmic or Algo Trading, or trades generated out of automatic execution and logic.

Algorithmic Trading Proposal:

• SEBI has proposed the creation of a regulatory framework for Algorithmic Trading.
• According to SEBI, all orders from an API (Application Programming Interface) is to be considered as an algo order. These orders are subject to stock broker’s control.
• The APIs used for algo trading are to be tagged with a unique algo ID. This ID is to be provided by the stock exchange that approves the algo.
• The stock exchange also has to approve each algo strategy- whether used by the client or the broker.
• The algo strategies have to be approved by CISA (Certified Information Systems Auditor)/ DISA (Diploma in Information System Audit) auditors.
• On the stock exchanges’ part, a system has to be developed to ensure that only the approved algos are being deployed.
• 2 factor authentication is to be used in every system which is used by the investor for algo trading.

What is Algorithmic Trading

• Almost everything in the digital world is based on algorithms. Algorithms leverage user data, behaviour and usage patterns, and take in pre-specified instructions to achieve certain goals.
• Algo trading refers to orders generated at superfast speed by the use of advanced mathematical models that involve automated execution of trade.
  • Even a split-second faster access is considered capable of bringing huge gains to a trader.
• The algo trading system automatically monitors the live stock prices and initiates an order when the given criteria are met.
• This frees the trader from having to monitor live stock prices and initiate manual order placement.
• It’s like asking a broker to buy or sell shares at a specific time or at a certain price, except that algorithmic trading is faster – computers analyse a lot more data than a human can in a given time and have less scope for error.
  • Also, significant price changes can be avoided because orders are executed within seconds.
  • Thus, investors can execute more trades faster since less time is required to manually monitor, select, buy, sell, initiate order placements and so on.

What is the role of API?

• Many stock brokers in India provides Application Programming Interface (API) access to their clients which establishes an online connection between a data provider (stock broker) and an end-user (client).
• API access permits the investors to use a third-party application that help them analyse market data or back-test a trading or investment strategy.
• These APIs are being used by the investors for automating their trades.

Algo trading advantages

• Rule-based decision making: It ensures that all trades follow a set of rules. It is important because traders and investors are frequently influenced by feelings and emotions while taking trade decisions.
• Reduce market impact: A trading algorithm can purchase shares and check immediately to see if the transaction has influenced the market price. It lowers the transaction costs and make automated checks on several market situations simultaneously.
• Minimize human fallacy: Since algorithmic trading works based on predefined instructions, it lowers the possibility of human traders making mistakes.

Algo trading disadvantages

• Monitoring: Even though the decisions are rule-based, automated trading systems do need constant supervision. Incidents of irregularities may be quickly detected and handled if the system is monitored.

Why is SEBI planning to regulate it?

• Though broker terminals are regulated and monitored by SEBI and the stock exchanges, algo programs aren’t subject to such rules and regulations.
• Such unregulated algos could be misused to lure investors with guarantees of higher returns and for systematic market manipulation. This poses a risk to the market.
• In the absence of regulation, a failed algo strategy could mean huge losses for retail investors. Meanwhile, programmers are selling algo strategies like assured return products.
• Algo trading has had its share of controversies. Eg: in 2015, it was reported that the NSE gave preferential access to some algo traders.

What is the way ahead?

• Market experts opine that algo trading will aid retail investors, especially those who aren’t engaged in stock trading full-time. It will also deepen the stock markets.
• It is also opined that introduction of restrictions would hinder market development especially as brokers may stop using API system given the difficulty in getting the permissions from stock exchanges. Many strategies would fail to get an approval because of their complex nature.
• Some are hesitant about the proposal as submitting the strategies for approval would mean revealing the formula.
• But, unregulated and unapproved algo trading poses a risk to the market. This is added to by the lack of regulation of 3^rd party algo providers and algo vendors. There is also a lack of investor grievance redressal mechanism.
• A section of the market community opine that the SEBI’s proposal is a step in the right direction. Regulation will protect investors’ interests and boost their confidence to take up algo trading.
• The risks of price manipulation and heavy losses for investors can be avoided if a set of rules is put in place.

Conclusion:

During the past 5 years, algo trading has taken roots in the Indian markets and is aiding retail traders. However, the lack of regulation leaves it open to misuse. Regulation would protect investors’ interest and could be a blessing in disguise for brokers to improve their technological prowess and to expand their client base.

Source: Indian Express

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