Since the Indian stock market has become an attractive playground for a large number of retail investors, the well-being of the common man has emerged as a major concern for the regulator, Securities Exchange Board of India (SEBI).

Algorithmic trading and sharing of Application Programming Interface (API) by brokerage firms are the tools of technology that have made stock investment and trading more precise, easier, and quicker, enabling many lakh of traders to participate in the stock market. But, in SEBI’s view, the technology that made the Indian capital market accessible to the hoi polloi is a two-edged sword that can cause grievous financial damages as easily as it can reap wealth.

SEBI launched a consultation paper on December 9, 2021, that expresses concern over algorithmic trading by retail investors and seeks views from the industry and the public on the potential threats it has identified with regards to, what is colloquially known as, algo trading.

While many industry veterans do understand the locus standi of SEBI with respect to its concern over the welfare of investors at large, they feel that the modus operandi suggested by the market watchdog in the consultation paper would also take the entire industry a few steps backwards. As per Nithin Kamath of Zerodha, the implementation of the Paper as is would ensure that the stockbrokers will stop offering any APIs, which would be two steps back in a tech-first future.

Regulator Concerns

As per SEBI’s paper, many brokers in India have started providing Application Programming Interface (API) access to their clients which establishes an online connection between a data provider (i.e., Stockbroker) and an end-user (i.e., Client).

SEBI has observed that these APIs are being used by the investors for automating their trades using third-party algorithms. Some API users are also building their own front-end features to develop their own trading apps with their own algo strategies. These are then being used by a large number of other users too. As per regulations, all algo strategies used by a broker need to be approved by exchanges. But in case of these users, neither exchanges nor brokers can identify if a particular trade emanating from an API link is an algo or a non-algo one.

SEBI aptly notes that such algos are being deployed without taking requisite approvals from the exchanges and hence, are unregulated.

The regulator is concerned that such unregulated/unapproved algos pose a risk to the market as they can be misused for systematic market manipulation. These algo-based apps are also being marketed to gullible retail investors by guaranteeing them higher returns.

Such algos also bring volatility in the market and since large number of users trade through such algo-based apps, they have the power to manipulate the market, making it prone to flash-crash, spoofing, layering etc. And, because these third-party algo-based apps are unregulated, there is no investor grievance redressal mechanism in place.

Measures proposed by SEBI put heavy onus on brokers

To counter the threats of unregulated algos, SEBI has proposed that all orders emanating from an API be treated as an algo order and be subject to control by stockbroker. A stockbroker distributing the API is also supposed to ensure that any algo trading happening through its API is tagged with the unique algo ID provided by the stock exchange after the approval is granted for the algo.

A third-party algo being used by any retail investor also needs to run on the servers of broker wherein the latter has control of client orders, order confirmations, margin information, etc. Stockbrokers also need to have adequate checks in place so that the algo performs in a controlled manner.

SEBI has also directed that the exchange shall not recognise any algo created by a third-party algo provider. This means only registered brokers are the legal entities through which trading and investing in stock market can be done, and not the third-party apps using brokers’ API. Such algo-based apps need to mention the name of their broker as a part of their testimonial and follow advertisement guidelines prescribed by the exchange. However, it shall be the duty of the brokers to ensure that the third-party algo providers who use their APIs meet such prescribed norms.

Any algo strategies that are being used to trade through a broker’s API needs to be provided by either the broker’s in-house services or through a third party that has entered into a contract with the broker.

Moreover, the broker providing the API is to be responsible for investor grievance or dispute redressal regarding any algo emanating from its API. And the broker will be responsible for assessing suitability of investor prior to offering algo facility.

SEBI has also suggested that a two-factor authentication should be built in every such system which provides access to an investor for any API/algo trade. And the software to be used to create the strategies should be approved by the exchange.

To top it all, brokers shall include a specific report on algorithm checks implemented by them as a part of annual system audit report submitted to the exchanges, in a format prescribed by the exchanges.

Clearly, SEBI wants to make the brokers liable for all algo trades emanating from the APIs they share. The question, however, is whether the brokers are ready to bear such liability?

Is SEBI asking too much from brokers?

In a Twitter Spaces discussion hosted by Sandeep Parekh, a securities lawyer and a visiting professor at IIM-A, Zerodha co-founder Nithin Kamath opined that the implementation of SEBI’s terms will not be possible by brokers and they will have to stop sharing APIs altogether.

Even the consultation paper pointed out that there is no way to identify whether any trade emanating through an API is happening because of an algo strategy or a human. Unless a user admits to using an algo for trading, the broker has no means to find out whether the execution of a trade was done by a human or if it was triggered due to an algo.

This essentially means that the broker is being forced to be responsible for something that is not under its control.

Making a broker responsible for third-party service providers’ investor grievances, dispute redressals and adherence to advertising norms may kill any enthusiasm on the part of brokers to share APIs with any investor.

How feasible is algo sharing?

In the discussion, multiple participants raised the concern over sharing an algo strategy, which is not only an intellectual property but also a trade secret. An investor might not want to share their algo strtegies with a broker who may have a conflict of interest, as the latter also have their own algo strategies.

An algorithm is a software that is protected under the Copyright Act 1957. To protect their algo strategies from being stolen, the API users will need to claim copyright for their algos.

Since there can be myriad trading and investment strategies, and they may keep changing, seeking exchanges’ approval for each algo, and every time there is a change in any algo, will be cumbersome for the API user as well as the broker.

The quantum of work it can create for the exchanges is also a concern for many investors and brokers because they believe that the workload would slow down the process of algo approval.

The real concern

As per experts, the advent of third-party trading apps that are not registered with the exchanges are a real threat to the ecosystem. These apps have mushroomed due to ease of access to APIs coupled with the software developer talent available in India. It is easy to create an algo based on an investment or trading strategy and then develop a user interface (UI) that would enable scores of users to trade through the app, once the APIs are available.

As SEBI points out, these unregulated Apps are violating the advertising guidelines and luring gullible retail investors by promising lucrative returns. Many such apps promise 4-digit returns on a double-digit investment. One can even find YouTubers dedicated to ‘educating’ consumers on how to make money through these apps. Such apps are the villains in the stock market ecosystem who can seriously damage investors' faith in capital markets. These unruly Apps are also a threat to the development of robust algo-trading ecosystem that can take the Indian stock-markets to even greater heights.

Since there are no checks and balances in place for unregulated trading Apps that have attracted many lakhs of traders and investors, any defect in their algos will trigger thousands of wrong trades, simultaneously. This can result in an avalanche of unwanted trades as other algos may react to the huge quantum of the rogue trade.

The larger the user base of an unregulated algo based App, the bigger is its threat to the stock-market. Unregulated algos can manipulate the market in multiple ways due to the sheer weight of the number of investors they hold.

However, SEBIs proposal, that seems to put the entire onus of algo-trading on brokers, may put a stopper on development of promising technologies even as it tackles the current threats.

Assume that the regulations that emerge from the Consultation Paper are not akin to throwing out the baby with the bathwater. If rot needs to be pruned away for growth of a healthy ecosystem, it is also imperative that the stake-holders of the fin-tech and capital market industry take cognizance of the unruly elements and self-regulate for the sake of a tech-first future.

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