Algorithmic trading has emerged as a tantalising prospect for many, especially among the younger generation. With promises of high returns and the allure of automation, retail investors are increasingly drawn to this domain. However, amidst the glittering promises lie risks often overlooked by those enticed by the potential gains.

Algo trading automates trading decisions, using computer algorithms to execute orders based on mathematical models and predefined instructions. Youngsters are increasingly drawn to algorithmic trading, as evidenced by the abundance of free resources available online—approximately 1.5 million videos on the subject. With nearly every teenager owning a smart phone with internet access, these videos are easily accessible and enticing. The increase in cloud-based solutions, the buzz around artificial intelligence (AI), and enticing advertisements promising automation-driven profits are the factors that further fuel this trend.

SEBI checks

To keep a check, SEBI has been evolving its framework over time to adapt to technological changes and mitigate risks. Key regulations in place include the following:

1.     Two factor authentication should be built in every such system which provides access to an investor for any API/algo trade. The software to be used to create the strategies should be approved by the Exchange.

2.     All algo orders shall be tagged with a unique identifier provided by the stock exchange in order to establish audit trail and the stock broker shall seek approval from the Exchange for any modification or change to the approved algos or systems used for algos.

3.   Stock broker needs to take approval of all algos from the Exchange. Each Algo strategy, whether used by broker or client, has to be approved by Exchange and as is the current practice, each algo strategy has to be certified by Certified Information Systems Auditor (CISA)/ Diploma in Information System Audit (DISA) auditors.

Risks

The key enabler of algorithmic trading is the Application Programming Interface (API), acting as the automation key for your trading strategy. Market participants often purchase APIs from various sources, including marketplaces and software vendors. These APIs are typically designed to interact with specific trading platforms or data providers.

Additionally, market participants may seek assistance from these API providers or other third parties to integrate the APIs with their trading systems and broker accounts. The key risk here is the availability and usage of grey market APIs.

Using grey market APIs can seriously harm investors and put them in a risky situation. Some individuals with questionable integrity exploit this gap to tempt investors into algorithmic trading using APIs by promising high profits. But if the algorithm doesn’t work as planned, it can result in significant losses for these investors. Since many third-party algorithm providers operate without regulation, investors have no way to address their concerns if something goes wrong. 

Secondly, the operations of unregulated algorithms on platforms can pose significant risks to the market. These algorithms, operating without oversight, have the potential to be exploited for systematic market manipulation. Moreover, their usage can introduce volatility, particularly as a considerable number of users engage in trading activities through these platforms.

Why investors must beware

In algorithmic trading, investors must be cautious of significant pitfalls like mis-sold algos and false promises of quick profits. Some lure with flashy guarantees of instant riches, but reality checks in: success requires planning, understanding, and sometimes, trial and error. Falling for these promises can lead to losses. It’s crucial for investors to be sceptical of such offers and focus on understanding algo trading, assessing risks, and making informed decisions aligned with financial goals. Diligence and patience are irreplaceable in investing.

Further checks proposed

In addition to SEBI’s periodic cautions to investors regarding the pitfalls of algorithmic trading services provided by unregulated platforms. SEBI is also proposing a more robust and enduring solution to address these gaps. This entails the implementation of a regulated registration requirement for algorithmic trading providers. Such a measure would significantly enhance accountability, investor protection, grievance redressal mechanisms, and establish a minimum standard of training and awareness within the industry. By imposing regulatory oversight and standards, SEBI aims to foster a safer and more transparent environment for retail investors engaging in algorithmic trading activities.

The writer is CBO, SBI Securities

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