In today's Finshots we discuss a consultation paper discussing the sensitive matter of regulating Algo trading

Markets

The Story

Let’s say you want to dive straight into the fascinating world of trading — stocks, commodities, options and all that. You fire up your brokerage app, take a look at all the stocks moving in a frenzy. Maybe you start parsing through the trading data, financials, charts and anything else that might give you an edge. And when things start looking just right, you punch in your trades.

Boom! You’ve now probably bought or sold something. And if your strategy is on the point you can actually end up making a lot of money.

But let’s suppose you want to replicate this strategy across multiple stocks. Let’s say you want to trade large volumes. Well, in that case, “fastest fingers first” won’t work anymore. It doesn’t matter how crafty your brilliant trading strategy is, it’s impossible to scale the idea with your slow hands.

Unless you use an algorithm — a series of instructions that a computer can execute for you. Through Algorithmic trading, you can combine the best of human intelligence and raw computational power. You can start analysing copious amounts of data and execute trades in milliseconds or even microseconds. A pace that the human brain can’t even comprehend.

All you have to do is figure out the instructions that can help you make consistent money. And when you do it right, it can lend you a sizeable advantage as far as daily trading routines go. However, if you’ve no idea what you’re doing, you could end up losing a lot of money or even worse, induce systemic risks for everyone involved.

That’s really bad.

Which is why SEBI — India’s market regulator recently published a consultation paper highlighting the increased risks surrounding algorithmic trading. Especially as more retail investors join the bandwagon. Their contention is simple — Algo trading is now extremely popular but it isn’t extensively regulated. This lack of regulation has invited a whole host of unregulated third-party Algo platforms on the scene. These platforms allow retail investors to buy custom-built Algo strategies off the shelf and investors are increasingly deploying it in the active markets.

This may sound like a genius endeavour. But it has its pitfalls.

Many of these ready to use Algos are not approved by regulators or stock exchanges. In most cases, these programs are written by people who aren’t Registered Investment Advisers or anywhere qualified enough to dole out financial advice. Some service providers have even been luring retail investors with the promise of ‘sure-fire profits’. And understandably those words have rung alarm bells in the offices of SEBI.

Because no matter how you slice and dice this, an algorithm isn’t a silver bullet. It’s just as good as the person who wrote it and the market regulator wants to bring them in line.

For starters, they want to define  what an Algo order actually means. And if the consultation paper goes into force, then every trade placed using an API (an interface that brokers offer so that your computer program can talk with their application) will be deemed an Algo order. Also, brokers will now have to get all these algorithms approved from the stock exchange before they’re deployed. And since in its current form, the onus is directly on the brokers to do all the heavy lifting, they aren’t particularly pleased about all the administrative overhead involved. For instance, brokers and exchanges will have to examine and approve every single complex trading algorithm, every time a new one is built (or even when an old one is modified).

Nithin Kamath, CEO of Zerodha thinks, the whole idea of coupling and mixing up APIs with Algos will essentially nudge brokers to stop offering APIs altogether.

He says “While customers using APIs today is a very small percentage of the business (0.05% of our business), but disallowing will mean our capital markets taking two-step backwards in a technology-first world. Disallowing APIs will also not solve the problem of unregulated algo trading platforms. They will just shift from using broker APIs to third party automation tools which aren’t in the control of the brokers.”

And then there’s the matter of propriety. If brokers and exchanges can go through these algorithms in detail, what’s stopping somebody from leaking this information. We don’t know.

So yeah, in its current form SEBI’s consultation paper on Algorithm trading has probably not hit all the right notes. But with enough people chiming in their ideas, things can only get better no?

Until then…

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*Zerodha, through its investment fund Rainmatter Technologies is an investor in Finshots.