The Securities and Exchange Board of India (SEBI) has released a draft circular for public comments, addressing the participation of retail investors in algorithmic trading. This move is designed to enhance market efficiency, improve liquidity, and provide retail investors access to the advantages of algorithmic trading (algo trading), which were previously reserved for institutional investors. With the evolving landscape of financial markets and increasing demand for algorithmic trading, SEBI aims to create a regulatory framework that allows retail investors to trade through algorithms with adequate safeguards.
Key Provisions of the Draft Circular
The key responsibilities of brokers under the proposed framework include:
- Algo Trading Permissions: Brokers must obtain permission from stock exchanges before providing algorithmic trading facilities to retail investors.
- Audit Trail: All algo orders must be tagged with a unique identifier to establish an audit trail.
- Modification of Algorithms: Any changes to the approved algorithms must be approved by the stock exchange.
- Brokers will also be required to have systems in place to identify and categorize all orders above a specified threshold as algo orders. They must not allow open APIs, ensuring that access to algo trading is restricted to identified vendors and users.
API Usage for Algo Trading
The draft circular proposes that brokers facilitate algorithmic trading via Application Programming Interfaces (APIs). APIs are software intermediaries that allow different systems to communicate and exchange data. This approach will enable third-party algorithmic trading providers (vendors) to offer their services to retail investors, but only through a controlled and monitored access system.
API Management: Brokers must ensure secure access through unique vendor-client specific API keys and static IPs to guarantee traceability.
Two-Factor Authentication (2FA): Brokers must use 2FA to authenticate API access and ensure enhanced security.
Empanelment of Algo Providers: To ensure that only trusted and compliant vendors are offering algo trading services, brokers will be required to empanel algo providers. These providers will act as agents of brokers and will need to meet certain eligibility criteria as set by stock exchanges.
Role of Exchanges: Stock exchanges will continue to be responsible for supervising algorithmic trading activities. Their roles include:
- Post-Trade Monitoring: Exchanges will monitor algorithmic trades and ensure that brokers comply with all regulatory requirements.
- Kill Switch: Exchanges must have the ability to use a “kill switch” to halt trading if an algo malfunctions, ensuring that the integrity of the market is maintained.
- Algo Categorization: Exchanges will categorize algorithms into “white-box” (execution algorithms with transparent logic) and “black-box” (algorithms with non-transparent logic) categories.
The new framework is designed with a focus on risk management. Some key safeguards include:
- Brokers are required to have robust systems in place to identify and mitigate risks associated with algorithmic trading.
- SEBI will ensure that brokers and algo providers are held accountable for any malfunction or misbehavior of algorithms.
- Algorithms that are developed by retail investors themselves must be registered with the stock exchange via their broker, ensuring a level of oversight and control.
Implementation and Timeline
The proposed regulatory framework is expected to come into effect in 2025, with exchanges and brokers given time to make necessary amendments to their systems and procedures. SEBI is also collaborating with industry stakeholders to finalize the standards for implementation.
