Sebi paper skirts illegality of retail algos

On December 9, the Securities and Exchange Board of India (Sebi) issued a consultation paper on retail algo trading and asked for feedback. Algorithms, or algos, are preset buy/sell rule-based decisions coded into software programmes, based on various price patterns. These programmes, when deployed through brokers, by using the Application Programming Interface (API), can act on their own in executing the trades as buy/sell signals are generated in accordance with the rules coded in the software. Algo trading has been allowed in India for more than a decade but for only institutional investors. As India went into lockdown in 2020 and work-from-home allowed trading-from-home as well, millions of new retail investors have jumped into trading. Within that, there has been explosive growth in algorithms being used by many newly minted and tech-savvy stock traders. Algos are running wild in the US too. The latest blog post of Cathie Woods, who runs the $50-billion fund, Ark Invest, asks whether algos are exacerbating inflation fears, leading to the recent market decline. “By some estimates, algorithmic trading accounts for roughly 70% of all trading in the US, and even higher percentages during periods of heightened volatility.”

In India, encouraged by the fact that algo trading can generate much larger volumes (since trading is not limited by the trader having to execute his trades, one by one, sitting in front of the computer screen -- the system can fire many trades per hour), brokers are hugely supportive of retail algo trading. They are offering their own, as well as third-party algos to clients. Retail algos are unregulated today. The question is, should they be regulated and, if so, how?

While a very tiny number of coder-cum-traders write their own algos, almost everyone else buys off-the-shelf algos from hundreds of algo creators. Large marketplaces have sprung up where algo creators showcase their wares often claiming eye-popping returns. Here is just one example from a Tradetron, a large marketplace (text unedited). “This Strategy is Meant For Some Small Investor Who Is Looking For High Income, Capital Requirement Is Rs 30,000/, You can easily make in average range from Rs 125,000 to 150,000/ on monthly basis.” That means 300-400 per cent return per month!

As in any marketplace, in the algo marketplace too, you have a wide variety of choices by applying dozens of filters. You can choose a strategy for stocks (arbitrage, bearish, breakout, bullish, buy & hold, intraday) and a dozen different ones for options (long or short gamma, long volatility, spreads, spend theta, etc). Strategies can be deployed in stocks, currencies, commodity markets, cryptocurrencies, and even the US market. You can go for a fixed fee, free or profit-sharing.

Anyone familiar with Indian market regulations can see how many things are wrong here. One, the illegal nature of these operations. These are all buy/sell recommendations (by one algo creator to many traders). They should immediately come under Sebi’s one of two regulations that cover investment recommendations — regulations for research analysts (RA) or investment advisors (IA). Almost no algo writer is registered with Sebi. Two, neither RAs nor IAs are allowed to share profits, which algo writers are openly doing. Three, algo APIs are allowing anyone to act as a portfolio manager. Since the client login details are available with the algo platform provider, they are automatically executing trades and managing money based on the strategies they offer. This is surely illegal. A page in Tradetron is titled “Realise your dream of being a PMS provider”.

Despite such glaring violations, Sebi had taken the stance, until July this year, retail algos don’t need to be regulated even though, not being registered as RA or IA, they illegally give buy/sell recommendations. After a couple of media articles highlighted how Sebi was ignoring industry whistleblowers seeking regulatory clarity, and not acting against those making wild claims or algos that could potentially aid market manipulation, the regulator began to work on a framework and started informal discussion with algo writers. 

Sebi’s recent consultation paper has sought to make brokers responsible for a variety of processes. Brokers have to run the algos on their own servers, ensure that trades from APIs have a unique algo ID, ensure the suitability of the product for clients, and be responsible for margins and redress investor grievances. Brokers also have to take approval for each algo strategy from the exchange, getting them certified by tech auditors, preventing unapproved tweaks to certified algos, sign individual agreements with third-party algo vendors, and ensure they meet exchange advertising norms.

However, in this mass of procedures, the Sebi paper sidesteps the main issue with retail algos today — that they illegally offer investment advice. All the paper says is “there needs to be a clarity on whether the services offered by the third party algo providers/vendors are in the nature of investment advisory services … since there is limited understanding with respect to the nature of services provided by various algo providers, brokers may obtain from their clients, details of nature and type of services taken from algo providers along with a confirmation as to whether the said services are in the nature of investment advisory services”.

A cursory look at the algo creators will show that the very purpose of algos is to offer buy/sell recommendations, often marketed by making wild claims. It is illegal to offer recommendations without being registered as IA or RA. Some claim to run Portfolio Management Services. Sebi should have started by asking all algo writers to be registered with it; instead, it merely wants brokers to ask their clients whether they are getting investment advice from algo writers! The illegality of retail algos is simply ignored!

The writer is the editor of www.moneylife.in

Twitter: @Moneylifers