You may be an active trader or find many around you who trade in stocks or derivatives (F&O). Although it’s a great way to make an extra income and may sound very intriguing, trading consumes a lot of time and effort. Moreover, it’s a sad reality that 9 out of 10 Indian traders lose money!
But imagine a world where you don’t have to learn complex techniques, spend hours looking for good trading opportunities and execute them manually. Instead, you use an automated system to strategise, place orders consistently, and monitor your trades in seconds! This is the magic of algorithmic (algo) trading, a seamless way to execute trades in the financial markets (stocks, futures & options, currencies, etc.).
Any trading strategy can be executed using pre-programmed ‘algos’, which contain instructions or criteria such as time, volume, and price. It’s fast, accurate, cost-effective, and helps avoid common issues manual traders face.
In this article, we explore the key regulations surrounding algo trading in India.
But First, Here’s a Brief History of Algo Trading:
Algo trading was first introduced in the United States during the early 1970s with the arrival of electronic trading systems. And it quickly gained popularity! Now, algo trades account for nearly 60-70% of the total trade volume in the US.
But what about India? Algo trading gained traction in our country in the late 2000s. Market regulator SEBI introduced algo trading in India through Direct Market Access (DMA) in 2008. Stock exchanges like NSE and BSE provide DMA as a facility that allows brokers to offer their clients direct access to the exchange's trading system through the broker's infrastructure. This allows clients to place orders directly into the exchange's order book, leading to faster execution and fewer errors compared to manual order entry.
Since then, it’s been mostly big financial institutions and High-Networth Individuals (HNIs) who have adopted algo trading in India. This is simply because the regulatory landscape surrounding algo trading only permitted these ‘big players’ to participate. Retail traders (individuals) in India couldn’t take part due to legal restrictions. However, we’ve been seeing a shift in this trend over the past few years!
Since 2019-20, many tech-savvy algo trading platforms have popped up as a result of technological advancements (especially with APIs - we will discuss this later in the article), and this has helped many retail traders participate in algo trading!
Did you know? Algo trading strategies account for nearly 50-55% of the total trading volume in India, as per data from the Association of National Exchanges Members of India (ANMI)!
What is SEBI? What Does It Do?
Way back in 1992, the Indian Govt. established the Securities & Exchange Board of India (SEBI) to become the guardian of India's securities markets. SEBI’s main job is to ensure that the markets work fairly and efficiently for everyone involved! Let’s take a look at what SEBI does:
- Investor Protection: SEBI’s primary objective is to protect the investor’s interest in the market. It has introduced many regulations so that investors are safe and have every bit of information about their investments.
- Promote Regulations: SEBI frames and promotes regulations for market participants like investors, listed companies, and brokers to ensure fairness and transparency in the market.
- Preventing Malpractices: SEBI detects and prevents malpractices like insider trading, market manipulation, and other scams in the Indian stock market. It holds the right to impose or penalise the violators.
[Wait, what’s insider trading? It’s an illegal practice that involves trading a public company’s stock based on material, non-public information about the company. For example, if a company’s CFO leaks important information about the company to a friend who owns shares in that company, it's insider trading. The friend could buy or sell shares based on information even before it is announced publically.]
- Education & Awareness: SEBI promotes investor education and awareness to enhance the financial literacy of Indian citizens. They conduct various meetings, seminars, and programs to educate people about the securities market, investment risks, and their rights & responsibilities.
- Developing the Secondary Market: The secondary market is where shares or other securities are bought and sold between investors rather than directly involving companies.
[For example- if a person wants to buy Reliance shares, he would purchase it from investors who already own the shares, rather than from the company itself]. It operates through established stock exchanges like NSE and BSE. SEBI has introduced reforms and initiatives to enhance liquidity, transparency, and efficiency in the secondary market.
SEBI’s Current Regulations on Algo Trading in India (for big institutions)
After SEBI permitted algo trading in 2008, certain brokerage firms, banks, or investment firms in India have used algos or high-frequency trading systems to generate profits for their clients (mostly HNIs or large corporations). In response to this development, SEBI has implemented a regulatory framework for these market participants:
- Regular System Audits: All firms/platforms that offer algo trading services should subject their trading system to a system audit by an authorised body every 6 months [system audit refers to an evaluation of the trading systems used]. This ensures that the requirements prescribed by SEBI are effectively implemented or not.
- Surveillance and Monitoring: To prevent market manipulation, stock exchanges are directed to take some safety measures like transaction monitoring, position limits, and pre-trade risk controls. These measures ensure effective surveillance and monitoring of the trades received through algo trading. Exchanges have to periodically review their measures to detect and investigate market manipulations.
- Order-to-trade ratio (OTR): Order-to-trade ratio is the ratio of the total volume of all orders, modifications, and deletions. SEBI has framed some OTR limits to prevent bulk ordering by traders. Traders exceeding these limits on any trading day face penalties set by SEBI. You can read more about these penalties in this circular!
- Co-location guidelines: SEBI has framed these guidelines to ensure equal access to the trading infrastructure, thereby enhancing equal opportunity in the market.
[Co-location refers to a service provided by the stock exchanges which allows some brokers to keep their servers in the same building that houses the exchange.]
What are SEBI’s Regulations on Algo Trading for Retail Traders?
Over the past few years (primarily since 2019-20), there's been a growing trend of retail traders participating in algo trading. This is because many brokers and algo trading platforms offer Application Programming Interface (APIs) to retail traders to deploy their trading strategies or execute trades effortlessly. An API is a set of protocols and tools that enable the software to interact with and place orders on different trading platforms, exchanges, or brokers. So anyone in India can use trading algorithms (no regulations or legislation that prohibit this practice).
And here's where we want to draw your attention! Interestingly, there are no real laws surrounding algo trading for retail traders in India (yet)! Without specific regulations, retail investors engaging in algo trading may lack proper safeguards and protections. Individual investors may face higher risks and potential losses because they often lack experience and resources.
So SEBI has stepped in to save retail traders from unfair practices or scams in the Indian algo trading space! They came up with a consultation paper (issued on December 9, 2021) to take views and comments from various stakeholders, market intermediaries, and the public on the practice of algo trading done by retail traders/investors, including their use of API and automated trade execution tools.
What is SEBI’s Proposed Framework for Algo Trading?
- All orders originating via APIs should be treated as algo orders and subject to control by the respective stockbroker. Moreover, the stock exchange approving the algo must attach/tag a unique ‘Algo ID’ for such orders.
- Only those algos approved by the stock exchange (NSE, BSE) and have a unique Algo ID must be deployed. Brokers can also use suitable technological tools to check and prevent unauthorised altering of algos.
- Algos developed must run on the servers of the exchange where they have complete control of client orders, confirmation, margin information etc.
- Stock brokers can provide in-house algo strategies developed by an approved vendor or they can source it from a third-party vendor. A formal agreement must be signed with each third-party vendor whose services are being availed. The exchange will provide no recognition to the third-party vendor providing the algo.
- Two-factor authentication should be built into every system that provides access to an investor for any API/algo trade. The software used to create the strategies must be approved by the exchange.
- Brokers must provide an annual system audit report on algorithm checks to the stock exchange. The format for the report will be provided by the stock exchange.
Simple Guidelines to Follow While Practicing Algo Trading in India
Here are several guidelines you can follow if you participate in algo trading in India:
- Choose a reputed broker or a reliable platform to deploy algo trading strategies.
- Understand the key risks associated with algo trading - there could be technical failures, market volatility, and issues related to over-optimisation.
- Use risk management tools like backtesting, stop-loss orders, portfolio diversification, position sizing etc.
- Use two-factor authentication for all algo trading platforms to prevent unauthorised access and maintain security.
- Stay disciplined, be patient, and seek professional advice whenever required.
Conclusion
While we don’t know the exact timeline for SEBI's new regulations on algo trading, we must stay alert and prepared for any potential changes. Algorithmic trading presents both opportunities and risks, and SEBI's role is to maintain a balance between promoting innovation and preventing market volatility. At the moment, SEBI appears to be supportive of allowing individual investors to engage in algo trading.
By following the market regulator’s existing and upcoming guidelines, retail traders and institutions practising algo trading can operate within the existing legal and ethical boundaries.
SEBI focuses on maintaining the integrity of the market and keeping investors/traders safe and educated. They are constantly forming new guidelines and frameworks to ensure harmony in the market. So always stay up to date with regulatory developments (we'll help you with this 😊). Also, implement risk management measures and maintain transparency while dabbling in algo trading!
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