Regulators have a tough task in promoting technology-based innovations while also protecting smaller investors and ensuring market stability. Algorithmic trading, wherein traders use automated programs to generate trading signals and to execute trades, is one such innovation that created a furore in 2012-13, leading to the issue of guidelines to regulate this segment. Algorithmic trading has since then grown in popularity and currently accounts for over 50 per cent of cash and derivative trading in India. The discussion paper issued by SEBI on algorithmic trading by retail investors takes a closer look at a segment of algo trading that has fallen through the cracks so far — the use of the application programming interface (API) provided by brokers to retail investors.

Clients who have programming skills use the APIs to create automated program codes for trading. Others have been using third party applications on the APIs to execute trades through their brokers. While the algo programs provided by brokers are vetted and approved by exchanges, the programs run on the APIs are so far unregulated. SEBI is right in being concerned about third party algos. There are many unregulated entities who are providing ready-to-use solutions off-the-shelf to traders. There are reports of mis-selling by these third party algo providers who have been promising traders certain fixed returns from the algos. The suggestion of the paper that brokers should obtain details from their clients about the nature of service being provided by these third party solution providers is the right approach. If they are giving trading advice based on their in-house research, they need to be treated as investment advisors and be governed under SEBI’s rules for Registered Investment Advisors. The products of these third party service providers should not be allowed to run on APIs provided by brokers, unless the entities are registered with SEBI and their programs have been audited and approved by exchanges.

While SEBI is right to frown upon third party automated trading, it needs to be a less stringent with algo programs coded by retail investors and run on broker APIs. The number of traders skilled enough to do the coding are likely to be few and these volumes are unlikely to be disruptive. Such practices should, in fact, be encouraged. Asking intermediaries to audit each of these programs coded by retail traders, get approval for every algo from the exchange and give them a unique ID, appears very complicated. The suggestion that all algos have to run on the broker’s server is also not feasible. One, traders would not like to share their programs with anyone, including their broker. Two, compatibility issues could arise in running client programs on the brokers’ servers. Ushering in such onerous rules could lead to the end of API-based trading in India. SEBI could instead ask brokers to tighten their supervision and trading limits for clients using APIs, but continue allowing these self-coded programs to be run on clients’ systems. Random checks can be done by brokers to check use of disruptive algos.