Mint explanator: Understanding the new rules of SEBI for retail investors in algo trading

However, with growing demand from retail investors, the Securities and Exchange Board of India (SEBI) introduced a framework to allow retail investors to participate safely in the Algo trade.

Mint Provides an overview of What this regulatory decision means for retail investors and what measures are taken to prevent potential risks such as market disturbances or unauthorized transactions.

What is algo trading?

Algorithmic trading refers to the use of IT algorithms (automated trading systems) which can process large amounts of data and execute orders in second fractions. It offers several advantages such as speed improvement, reduction in transaction costs and better liquidity, making it an attractive option for investors.

Currently, institutions can use direct access to the market to trade using algorithms. The SEBI circular, on February 4, extended these advantages to retail investors by introducing a complete regulatory framework which ensures the safety and integrity of the market.

Retail investors will be authorized to participate in algorithmic trading, but only through registered brokers which must obtain the exchange authorization for each Algo strategy. This decision should reduce transaction costs for investors.

Role of brokers

The brokers will be the guards, facilitating the access of retail investors to algorithmic trading via application programming interfaces (API). They will guarantee compliance with regulations, monitor the trades and manage the risks.

All Algo orders will be labeled with a unique identifier provided by the scholarships to ensure transparency and maintain an audit track.

They will ensure that access to the API is secure by implementing two factors with two factors and using static IPs. Only authorized Algo suppliers will be allowed to access the broker’s API.

They will also be responsible for resolving complaints from investors linked to algo trading.

Role of Algo suppliers

The suppliers of Algo (companies or fintech companies which create and provide algo trading solutions) must be poverty with scholarships. Brokers are required to make reasonable diligence before joining these providers.

The algos that retail investors develop themselves must be recorded with exchanges if they exceed certain thresholds in terms of orders per second. These recorded algos can be used by retail investors for their immediate families (spouse, dependent children and dependent parents).

Experts said it could include substantial risks. Kalash Lad, partner of Little & Co said that software problems could cause errors in the businesses, resulting in potential financial losses, while delays in the execution of the order, in particular during the Volatil market conditions, could lead to missed opportunities or unforeseen transactions.

“The use of unregulated platforms makes investors vulnerable to fraud and limits access to dispute settlement mechanisms. Managing his own algorithmic strategy can induce emotional stress, leading to hasty or irrational decision-making, “he added.

Meanwhile, exchanges will supervise the operation of Algo professions, ensuring that market disturbances are prevented. This understands the possibility of triggering a “killing switch” to stop the defective algos.

White and black box algos

The white box algos (execution algos) are transparent and reproducable algorithms. Retail investors can use them freely, provided they meet the necessary requirements and are recorded with brokers and exchanges.

Black box algos are proprietary systems where the underlying logic is not disclosed. The providers of these algos will have to register as research analysts with exchanges and submit detailed research reports for each algo they offer.

LAD said that the categorization of algorithms in “execution” and “black box” has an impact on retail investors by increasing transparency. “The execution algos or the white box allows investors to modify strategies based on market conditions, which gives greater control. Meanwhile, Black Box offers less flexibility because their internal logic cannot be changed, “he said.

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Implementation and potential risks

The Industry Standards Forum for brokers under the aegis of the scholarships will finalize the standards of implementation by April 1. The provisions of the new framework will come into force from August 1.

Experts believe that this framework allows retail investors to engage in Algo trade under strict surveillance, to improve market efficiency and liquidity. “Increased automation can influence traditional negotiation strategies, accelerating the adoption of algorithmic methods,” said LAD.

The executive has introduced guarantees to guarantee the participation controlled by retail investors in the trade in Algo, which, according to experts, could improve liquidity thanks to higher regulated negotiation volumes.

“With the brokers necessary to pre-apply and monitor all retail strategies, only compliant and well tested strategies will be deployed, promoting stable liquidity without excessive speculative exchange. The marking and monitoring of Algo’s orders will improve the visibility of the flow of orders, leading to more predictable liquidity conditions, “said LAD.

However, market -oriented transactions could also lead to high market fluctuations and poorly designed algos can be vulnerable to cybermenaces, experts warned.

“Excessive dependence on automation may not explain the unforeseen market conditions, which potentially leads to unfavorable results,” said Ashish Padiyar, director partner, Bellwether Associates LLP.

He said that if an increase in market liquidity will allow more competition, it could arouse concerns about potential market volatility due to inexperienced participants using complex negotiation strategies.

“This can also cause increased volatility, especially if algorithms react similarly to market events. The regulations are designed to ensure that Algo’s growth in trade is accompanied by appropriate guarantees to maintain market stability. To what extent it works well, time will tell us, “said Padiyar.