The future of Algo Trades

I have a piece with Parker Karia and Pragya Garg on the future of algo trading and its regulations in today's opinion page of Financial Express. Please see below the full piece:

"Among the flurry of consultation papers issued by the securities market regulator over the past few months, in December 2024. SEBI proposed significant changes to its framework governing algo trading. To recap quickly, algorithmic trading, or algo trading, refers to any trading activity that automates trades, and does not require manual intervention to place any orders, or monitor prices.

There are two ways in which one can carry out algo trading. The straightforward method is to use the algorithms provided by the stock broker, if that is a facility your broker provides. The other route is through APIs (Application Programme Interface), which enable electronic systems to connect with each other.

Think of it as a data pipe which carries your algorithm. APIs enable the transmission of information, and as a result, a third party can create a code that will execute itself on the broker’s platform. APIs are what enables you to book an Air India flight on Goibibo or avail a loan from a bank through a distributor.

In the context of algo trading, third parties provide their algo on say, Platform X, which is connected to the broker’s platform through an API. Thus, orders placed by the client on Platform X get passed on to the broker. Now, while a broker can identify that an order is coming in through an API, it cannot verify that the order is an algo order.

In 2021, being concerned with the rise of unregulated and unapproved algos, SEBI had proposed to treat all API orders as algo orders. This was a flawed approach, and a departure from SEBI’s mission to encourage innovative and digital solutions in securities market, as the regulator’s proposal would have retarded connectivity between brokers and other sophisticated players connecting to them for non-algo purposes.

It appears that the proposal has been scrapped, and after extensive consultations with the industry, a more practical approach has been proposed.

With respect to API orders, SEBI has suggested that an ‘Order per second’ threshold be specified, and that all API orders above such threshold would be treated as algo orders.

Secondly, SEBI has proposed to bring ‘algo providers’ within the regulatory ambit. These algo providers would be agents of stockbrokers, similar to the present ‘Authorised Person’ or the erstwhile sub-broker concept. Algo providers would also have to register with the stock exchange, and also get their algos approved by the exchange. This would ensure that the broker is responsible for customer grievances, and the redressal mechanism deployed by SEBI would be available to clients of algo providers.

Individuals who design their own algos would also have to get them approved by the stock exchanges through their broker. These can then be used by the investor’s immediate family as well.

The regulator has also sought to categorise algos into ‘White Box’ and ‘Black Box’ algos. White Box algos, also known as ‘Execution Algos’, are those which execute orders based on fully transparent algorithms, where the logic, decision making processes and underlying rules are accessible and understandable to users and is replicable. On the other hand, Black Box algos are algos whose logic is not known to the user and is not replicable, or where the user cannot see the internal workings and rationale of the algo. For providing Black Box algos, one would be required to register as a research analyst, and for each algo, a research report would have to be maintained, and in case of any change in the logic governing such algo, it would have to be registered afresh, along with a new research report.

The proposed framework places significant responsibilities on stock brokers. Brokers would have to put in place systems and procedures to detect, identify and categorize all orders above the specified ‘order per second’ threshold as algo orders. They would also have to make sure to have the ability to distinguish between algo and non-algo orders. Further, brokers would no longer be permitted to offer open APIs, to ensure identification and traceability of the vendor and end user. Whether such severe restrictions are required or not, in view of the measures such as the ‘order per second’ threshold, may require some more thought. APIs have uses beyond algo trading. The proposed circular should not stand in the way of such non-algo trading use case scenarios.

There is a fair bit of work that the stock exchanges would also have to do. First, they have to define the roles and responsibilities of brokers and empanelled vendors, and lay down the criteria and process of empanelment of vendors. A turn-around-time has to be specified for registration of algos, including a fast-track registration for certain algos, such as White Box algos.

Further, the stock exchanges would have to deploy additional resources as well. The exchanges would be required to conduct post trade monitoring of algo orders and trades and put in place a Standard Operating Procedure for testing of algos. Further, they must have the ability to use a ‘kill switch’ to stop malfunctioning algos.

Additionally, they would have to supervise/inspect that stockbrokers have the ability to distinguish between algo and non-algo orders, and issue detailed operational modalities, regarding the roles and responsibilities of stock brokers and algo providers including risk management system of stockbrokers for API orders.

The present proposal thus seems to be more carefully thought out, and seeks to adopt an approach that strikes a balance between the interests of the stakeholders and concerns of the regulator. In another positive move, in its last board meeting of 2024, SEBI’s board granted approval for the recognition of a ‘Past Risk and Return Verification Agency’ (PaRRVA), which shall carry out the verification of risk-return metrics inter alia in relation to algo trading.

There are still some points which may require a re-think as algo trading picks up. For instance, SEBI’s earlier question of whether an algo should be a facility provided by a research analyst or an investment adviser, or a separate class of regulated entities altogether. With the proliferation of AI, the roles, responsibilities, risks and liabilities are getting redefined.

However, there are few items that may require consideration soon, if not now. For instance, algos may be designed by artificial intelligence. The risks and liabilities that may arise out of such instances must also be deliberated upon carefully, along with the roles and responsibilities of the elements involved. While there may never be one right answer, and regulation of something as innovative as algo or AI based algos is bound to create some unnecessary bureaucracy in the process, it is important for the regulator to at least have some grip on something which could have systemic impact on the markets."