SEBI Proposes New Rules for Retail Investors in Algo Trading: Key Highlights

On Friday, 13th December 2024, SEBI (Securities and Exchange Board of India), released a consultation paper on algorithmic trading. “This particularly focuses on the participation of retail investors in algo trading.”

Let’s start with a quick recap of algo trading's emergence in India. 

In 2008, algorithmic trading was formally introduced in India by SEBI through the Direct Market Access (DMA) Facility. Initially, only institutional investors (including hedge funds, mutual funds, and proprietary trading firms) were allowed to do algo trading. 

But how come this can restrict retail investors from joining this bandwagon? In 2016, several companies launched APIs which allowed individual investors to programmatically place buy and sell orders.

Trading was done via marketplaces (independent algo providers) that were connected with different brokers. The brokers gave APIs (Application Programming Interfaces) to those who wanted to develop their own trading algorithms. However, these internet-based trades are not directly reflected on the exchange. 

Were these orders regulated? Absolutely, not! 

This resulted in the rise of unregulated platforms that promised market-beating returns. Unfortunately, investors faced potential losses greater than expected. 

Looking at such fraudulent activities, SEBI issued a consultation paper in December 2021, outlining the risks and proposing regulatory measures.

SEBI proposed that any trade executed via an API should be classified as an algo-generated order. Also, brokers had to ensure that all third-party algos, particularly those used by retail investors, received exchange approval.

After almost a year, in September 2022, SEBI rolled out another set of guidelines, mainly focusing on brokers. This prohibits them from partnering with unauthorized platforms that lure investors with anticipated future returns of algorithms.

So, till now, algorithmic trading for retail investors has been more of a guardrail. 

However, the growing demand for algo trading opportunities from these investors can’t be ignored. That’s why it’s the need of the hour for SEBI to rework its regulatory framework to enable retail investors' participation in a fair way. 

The latest Consultation Paper entails everything that will increase transparency, efficiency, and fairness in the algorithmic trading system. 

Read on to find out what it proposes! 

What Does the Consultation Paper Propose?

Categorization of Algorithms: 

The algorithms are categorized into two types: 

• White Box Algos/Execution Algos: Here, the logic is transparent which users can replicate. 
• Black Box Algos: Here, the logic is not disclosed. For black-box algorithms, the providers will need to register as research analysts and maintain detailed reports on the algorithm's logic and functionality.

Regarding The Use of Application Programming Interface (API):

• When providing algo trading services through APIs, brokers act as the main party (principal). Any entity (fintech/vendor) providing algos is referred to as “algo provider.” These will act as the broker's agents while using the API provided by the broker. Also, “algo providers”, which develop and manage trading algorithms, need to be empanelled by exchanges to ensure they meet specific eligibility criteria. 
• Orders that go above a specified order per second threshold, sent through the broker's API, will be considered “algo orders.” These orders must be tagged with a unique identifier provided by the Stock Exchange. 
• Retail investors who create their own algorithms must register these algos with the Stock Exchange through their broker. Once registered, these can be used by the investor and their immediate family members (self, spouse, dependent children, and dependent parents).

For Stock Brokers:

Do’s (✔)

• Obtain approval from stock exchanges for each algorithm before offering algo trading facilities. 
• All algorithmic orders must be given a unique identifier to maintain an audit trail and comply with SEBI’s monitoring requirements.
• Must have systems and procedures to detect and categorize all orders above the specified threshold as “algo orders.”
• Access to APIs should only be allowed via a unique API key specific to the vendor/client and a static whitelisted IP address. 
• Use OAuth (Open Authentication) for authentication. 
• Access to the API must be authenticated via two-factor authentication (2FA). 
• Only work with empanelled algo providers and handle any related complaints.
• Any changes to the approved algos or systems must be approved again by the stock exchange.

Don’ts (x)

• Should not permit open APIs. 
• Do not allow the use of authentication methods except OAuth.