The Good, Bad And Ugly Of Algorithmic Trading

Securities and Exchange Board of India (SEBI) has drawn a regulatory framework for algorithmic trading in an attempt to protect retail investors’ interest and prevent any possible manipulations in the secondary market. What led it to impose regulations? Armaan Madhani explains the how and why of algorithm trading 

Life is a process of evolution. Change is at the very core of evolution and is also inevitable. It seems like artificial intelligence (AI) is the universal answer for evolution in every single field. To quote Jeff Bezos, the founder of Amazon, “We are at the beginning of a golden age of AI. Recent advancements have already led to inventions that previously lived in the realm of science fiction — and we have only scratched the surface of what’s possible.” On similar lines, when it comes to the volatile, uncertain, complex and ambiguous (VUCA) world of investing and trading, change is the only constant. There is no two ways about it and AI probably looks like the way forward.

Whether you are aware of it or not, algorithms are increasingly becoming a ubiquitous part of our lives. An algorithm is a set of instructions for solving a problem or accomplishing a task. It is a step-by-step procedure used for calculations, data processing and automated reasoning. Algorithmic trading is the process of using pre-programmed trading instructions to execute trading orders at high speed in the financial market. Investors and traders use trading software and feed it trading instructions based on time, volume and price. Once the set instructions are triggered in the market, the trading software executes the orders set by the investor.

For example, let’s say you follow a simple strategy wherein you purchase a particular stock if its price falls below the 10-day moving average and liquidate it when the scrip rises above the 10-day moving average. To execute the strategy, you will have to continuously and carefully monitor the technical charts for changes. In addition, there is a high possibility that you could miss out on the optimal entry or exit price. It is a laborious task, which is difficult to run at scale. In this instance, algorithmic trading could be your friend. Algorithms can collect data for a pre-defined trading strategy and back test the strategy to analyse historically the profit and loss.

The algorithm could then monitor live market data and automatically trade whenever the strategy generates a buy or sell signal. Generally, algorithmic trading is used by mutual funds, hedge funds, insurance companies, banks, etc. to execute a large number of high-volume trades that are otherwise impossible for humans to undertake. The merits of algorithmic trading include automatic order placement without any human errors and reduction of transaction costs. It also helps avoid significant price changes as the orders are executed in milliseconds or even microseconds. In the US and other developed markets, high-frequency trading and algorithmic trading accounts for roughly 70 per cent of equities’ market share.

Algorithmic trading isn’t a new phenomenon in the Indian financial markets. In April 2008, market regulator Securities and Exchange Board of India (SEBI) introduced algorithmic trading by allowing ‘direct market access’ (DMA) facility to institutional clients. In short, DMA allows brokers to provide their infrastructure to clients and gives them access to the exchange trading system without any intervention from their part. Initially, it was provided only to institutional clients. Nevertheless, the facility brought down costs and saved time for institutional investors. After the stock exchanges started leasing co-location servers to brokers and financial technology (fintech) firms, retail participation started burgeoning.

During 2018 in India, algorithmic trading across the cash and derivatives markets as a percentage of the total turnover catapulted to 49.8 per cent in eight years from an average of merely 9.26 per cent in 2010. Currently, stock exchanges only provide approval for algorithmic trading which are coded and drafted by brokers. However, there are several unregulated third-party applications or algorithm providers and vendors that offer off-the-shelf automated strategies. These have gained popularity among scores of retail investors over the bull phase last year. These vendors are extending algorithm trading services without taking requisite approvals from authorities.

The Flip Side
In this scenario, the hiccup is that for the trades deployed by retail investors using these third-party application programming interface (API), both brokers and exchanges are unable to identify if the particular trade emanating from an API link is manually executed by the retail investor or automatically by an algorithm. SEBI fears that since such third-party algorithm vendors are unregulated and there is also no investor grievance redressal mechanism in place, retail investors could be lured in by guarantees of lofty returns. Further, this technology could be misused by miscreants for systematic market manipulation as well.

Not to mention, in cases where the algorithmic trading strategy simply fails to perform in the expected manner or better yet misfires, the consequences can lead to colossal losses for investors and heightened systemic risk as well. Hence, SEBI recently floated a consultation paper on algorithmic trading by retail investors, including the usage of API access and automation of trades, which turned plenty of heads and soon became the much coveted talk of the town. The objective of this paper is to seek comments from various stakeholders including market intermediaries and the public i.e. retail investors.

Need for Control
SEBI has drawn a regulatory framework for algorithm trading in an attempt to protect retail investors’ interest and prevent any possible manipulations in the secondary market. As per the paper, each algorithm strategy, whether used by broker or client, has to be approved by the exchange and as is the current practice, each strategy has to be certified by a Certified Information Systems Auditor (CISA) or a person with Diploma in Information System Audit (DISA). All orders emerging from APIs should be treated as algorithm orders, be subject to control by broker and should be tagged with a unique algorithm ID issued by the stock exchange, post approval. All algorithms developed by any entity have to run on the servers of brokers wherein the broker has control of client orders, order confirmations and margin information.

Double level authentication should be built in every such system which provides access to an investor for any API or algorithm trade. Brokers need to deploy suitable and adequate technological tools to ensure that there are appropriate checks and controls to ensure no unauthorised shenanigans take place. SEBI has suggested that brokers can either provide in-house algorithm strategies developed by an approved vendor or outsource the services of third-party algorithm providers or vendors. Stock brokers will be responsible for all algorithms emanating from its APIs, assessing investor suitability prior to offering algorithm facility and redressal of any investor disputes.

Conclusion
Algorithm trading is the natural evolution of trading manually. It is one of the best ways for investors to ensure that they do not commit physical or emotional errors while trading and miss out on potential profits. However, algorithmic trading is highly technical and requires immense knowledge related to the financial market, data analysis and computer programs. With regard to the interests of retail investors, SEBI’s proposal is a big step forward in the right direction. The regulatory framework will boost confidence amidst retail investors who wish to engage in algorithm trading. With a set of rules in place, there won’t be any price manipulations and investors would be able to steer clear of any heavy losses in the process. The move comes as a golden opportunity in disguise for stock brokers offering APIs to customers.

It thereby empowers them to craft their own algorithm trading strategies. These brokers can now focus on scaling up their technological prowess, expand their client base, increase the wallet share from existing clients and develop a formidable competitive edge. On the contrary if these proposals are implemented, there is a high possibility that brokers may stop using the API system as getting the requisite permission from the stock exchanges for every single complex trading algorithm is an exhausting process. Eventually, investors will shift from using broker APIs to third-party automation tools which aren’t in the control of the brokers. Only time will tell how this saga plays out.