I have a piece with Raghvamsi Meka and Parker Karia on the Algo trading rule of SEBI in today’s Financial Express The full piece is reproduced below:
The Securities and Exchange Board of India (SEBI) recently issued a circular addressed to stock exchanges and brokers in relation to performance/return claimed by unregulated platforms offering algorithmic (algo) strategies for trading.
In its circular, the regulator notes that algorithmic trading services and strategies are being offered to investors for automated execution of trades and are marketed, claiming high returns on investment by various unregulated platforms. Some of the algo strategies are even assigned ratings, which SEBI rightly believes to constitute mis-selling of services and strategies to unsuspecting investors. SEBI has further noted that in certain instances, stock brokers are providing algorithmic trading facilities through such unregulated platforms.
In view of the risks associated with this unregulated activity, with the lack of adequate investor protection and grievance redressal mechanisms, the regulator has mandated that stock brokers providing algo trading services shall neither make any direct or indirect reference to the past or expected future returns or performance of the algorithm, nor shall it associate with any platform providing such references. Offering a week’s time to comply with the above, the circular instructs stock exchanges to ensure compliance of the above by the stock brokers by i) making relevant amendments to its bye-laws, rules and regulations; ii) disseminating the information to brokers; and iii) by submitting a compliance report within sixty days of the circular.
SEBI’s previous warnings and proposed framework
This is not SEBI’s first attempt to regulate algo trading. In June, SEBI issued a press release cautioning investors against falling prey to algo trading services and strategies offered by unregulated platforms. In fact, in December 2021, the regulator proposed a framework for algo trading by retail investors, which sought to address the rise in the use of Application Programming Interface (API) access, which inter alia allow for automation of trades. These APIs are used to establish a connection between the trader and the broker in order to obtain real-time quotes and pricing data and also enables traders to use a third-party application to place orders in the market which may or may not be based on an algorithm. SEBI’s concern with the use of APIs was that orders coming in through APIs are not subjected to any scrutiny, and whether there is an algo behind the API cannot be determined. Thus, it was proposed to treat all orders emanating from APIs as algo orders, which would have to be appropriately tagged and certified.
The proposed framework was flawed, as the classification of all API trades as algo trades was inaccurate and unfair, and the regulator’s proposal, however well-intentioned, would have contributed to the contraction of an otherwise booming API industry. Further, the proposed framework sought to impose a heavy burden on stock brokers, and did not take into account the nature of algo strategies.
Concerns with the current approach
It is quite clear that SEBI’s core concern with algo trading appears to the mis-selling of algo services and strategies, especially in view of the quoting of past performances, prediction of future performance and assignment of ratings. While such marketing tools can undoubtedly lure unsuspecting or unaware investors, having an undesirable effect, the regulator appears to ignore the fact that quoting past performances is not an uncommon practice in the securities market. For instance, mutual funds routinely quote past returns as an indicator of the success of the fund.
Another way to look at this is – on what parameters would an investor ascertain whether a particular algo strategy or service would be appropriate for the concerned investor? SEBI’s move will essentially retard the algo trading industry, as investors have essentially been deprived of a viable metric to ascertain which algo service or strategy is appropriate for them. Without being able to effectively ascertain the benefits of the algo service or strategy, or being able to compare various algo strategies, investors may refrain from availing algo trading services.
Algo strategies offered by stock brokers through third party platforms, or otherwise, would have been duly approved by the stock exchanges, and necessary internal controls to mitigate risks would be in place, among various other safeguards and conditions. By prohibiting stock brokers from advertising the past performance data of the algo strategies, SEBI may be unintentionally herding the investors to the dark (unregulated) side, which may continue to provide performance indicators. It is also important to note that past performance may or may not be an indicator of future success. In fact, that is the exact reason why such performance indicators are accompanied with appropriate disclosures and disclaimers, as in the case of mutual funds.
The way forward
Instead of the practical ban on algo trading, in order to mitigate the risks, the regulator could have mandated that all performance indicators be accompanied with appropriate risk disclosures. Guidelines in relation to the manner in which past performance should be gauged can be framed as well, considering the atypical nature of algo trading.
Interestingly, SEBI does not seem to be in a hurry to pursue the most viable and apt approach (which it itself suggested in its consultation paper) – i.e., to bring algo strategies under the ambit of investment advisory. In its consultation paper, the regulator had admitted that there isn’t sufficient data to ascertain whether providing algo strategies comes under the scope of an investment adviser. However, quite some time has elapsed since then, suggesting that at least preliminary data would be available to adopt a more practical and balanced approach. Bringing algo providers under the SEBI laws on investment advisers or research analysts, with suitable modification to the extant regulations, could help regulate their practice and restrict mis-selling of algos, while appropriately distributing the compliance burden amongst the market participants, including the regulator. Notably, in the US, members are required to register associated persons who are primarily responsible for the design, development or significant modification of ‘algorithmic trading strategies’ (or for the day-to-day supervision or direction of such activities) as ‘Securities Traders’.
In the longer run, a regulated registration requirement would go a much longer way in ensuring accountability, investor protection, grievance redressal and a minimum standard of training and awareness as opposed to the latest step taken by SEBI, which essentially looks like a stop-gap measure with potential to create an existential threat to the algo market and be counterproductive in its stated aim of investor protection. Be it a separate regulation or inclusion of algo traders within the scope of investment advisers, it appears that SEBI needs to come up with a comprehensive policy to address the concerns of all stakeholders and balance the interests of all parties in the algo trading space – sooner rather than later.
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