Algo trading coming soon to a terminal near you

Algorithmic trading which has remained the preserve of large institutions could soon be open to India’s retail investors as well, with the market regulator proposing a framework with critical roles for brokers and stock exchanges.

In a consultation paper floated on Friday, the Securities and Exchange Board of India (Sebi) suggested making algo trading available to retail investors through licensed brokers, who will register clients’ algorithms with exchanges, ensure compliance with rules, and watch for irregularities.

In 2012, Sebi opened algorithmic trading for institutional investors through its Direct Market Access (DMA) facility. Its latest proposal aims to bring benefits such as faster order execution, reduced transaction costs, greater transparency, better audit trails and improved liquidity to retail investors as well. Sebi proposed that these algorithms may be extended to an investor’s immediate family, including spouse, dependent children and parents.

Brokers to ensure responsible ops

Brokers will play a crucial role in ensuring that algorithms are operated responsibly, and offer oversight to prevent market disruptions. They will be required to install stringent safeguards, including unique identifiers for all algorithmic orders, two-factor authentication for Application Programming Interface (API) access, and enhanced oversight of any third-party algorithm providers or fintech companies that might offer their services to retail investors. Only algorithms that meet specific criteria defined by the regulator will be allowed.

Sonam Srivastava, founder and fund manager at Wright Research, a financial advisory firm, said the proposed safeguards could ensure the balance between innovation and investor protection. “These measures enhance transparency and create better audit trails, helping ensure that market integrity is maintained,” she noted.

The proposed framework introduces a distinction between execution algorithms (also known as White Box algorithms) and Black Box algorithms. Execution algorithms are transparent and replicable, meaning their underlying logic can be understood and duplicated. Retail investors will be free to use them, subject to the new regulatory requirements.

On the other hand, Black Box algorithms are complex, proprietary and not disclosed to the user. The use of such algorithms will require the algorithm provider to register as a research analyst with stock exchanges. The provider will also need to maintain detailed reports on the strategies and logic behind the algorithms, which will be reviewed by the exchanges to ensure market integrity.

Exchanges’ role still critical

Stock exchanges’ role will remain critical in monitoring and regulating algorithmic trading. They will continue to oversee post-trade surveillance, including the use of “kill switches” to halt malfunctioning algorithms. They will also ensure that brokers meet their compliance obligations and set timelines for the registration and approval of different types of algorithms to help streamline the process for retail traders.

Dale Vaz, co-founder and chief executive of Sahi, a mobile-first trading platform, emphasized the need for brokers to ensure that platforms are both sophisticated for experienced algo traders and easy to use for beginners. He also stressed the need to educate retail investors on the risks of algo trading, particularly on the differences between execution and Black Box Algorithms.

While APIs provided by discount brokers make algo trading accessible, operational risks are associated with monitoring multiple accounts and orders from various algo providers, Srivastava of Wright Research said. Brokers will need to enhance their systems to monitor real-time trading activity and ensure that any irregularities are detected early. She also emphasized the need for robust infrastructure to manage the technical complexities involved in algo trading, particularly during volatile market conditions.

Retail participation boost

Despite these challenges, Srivastava believed the proposed framework would likely increase retail participation in algo trading. “The democratization of algo trading will attract more tech-savvy retail investors seeking automated and data-driven strategies,” Srivastava added.

“Effective risk management systems are essential to prevent cascading errors during volatile markets. Brokers must monitor retail participation at scale, identifying and mitigating risks that arise from excessive or erroneous trades,” Srivastava added.

Sebi has asked stakeholders to submit feedback by 3 January.

Ketan Mukhija, senior partner at Burgeon Law, said the effectiveness of the framework would hinge on rigorous enforcement and continuous evaluation and retail access would necessitate robust education on the complexities and risks

Nirbhay Vassa, group chief financial officer of Abans Holdings Ltd, a broking company, said the fast-paced nature of algo trading requires continuous monitoring and adaptive safeguards that evolve alongside technological advancements. “Complexity of algorithmic trading poses a steep learning curve for retail investors. Limited awareness, technical barriers, and fear of financial loss can hinder participation,” he said. Technology and AI-driven insights could play a crucial role in compliance, real-time monitoring, and investor protection.