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Capital markets regulator Securities and Exchange Board of India (Sebi) today floated a consultation paper on regulatory framework for algorithmic trading (algo trading) by retail investors to make such trading safe and prevent market manipulations.

The objective of this paper is to seek comments from various stakeholders including market intermediaries and the public on algorithmic trading being done by retail investors including use of API access and automation of trades using the same.

In market parlance, algo trading refers to any order that is generated using automated execution logic. It automatically monitors the live stock prices and initiates an order when the given criteria are met. This also frees the trader from having to monitor live stock prices and initiate manual order placemen.

Sebi had earlier constituted an internal working group which deliberated on the issue of unregulated algos being used by investors especially retail investors and ways to prevent the same. The working group held meetings with various market participants and based on deliberations, the working group submitted their recommendations.

In its consultation paper, the regulator has proposed framework for algo trading done by retail investors including use of Application Programming Interface (API) access and automation of trades. Currently, exchanges are providing approval for the algo submitted by the broker.

However, for the algos deployed by retail investors using APIs, neither exchanges nor brokers are able to identify if the particular trade emanating from API link is an algo or a non-algo trade.

"This kind of unregulated/unapproved algos pose a risk to the market and can be mis-used for systematic market manipulation as well as to lure the retail investors by guaranteeing them higher returns.

The potential loss in case of failed algo strategy is huge for retail investor," Sebi said.

Since these third-party algo providers/vendors are unregulated, there is also no investor grievance redressal mechanism in place, it added.

Under the proposal, Sebi suggested that all orders emanating from an API should be treated as an algo order and be subject to control by stock broker and the APIs to carry out algo trading should be tagged with the unique algo ID provided by the stock exchange granting approval for the algo.

It, further, said that 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 auditors.

Also, brokers will deploy suitable technological tools to ensure that appropriate checks are in place to prevent unauthorized altering or tweaking of algos.

They need to have adequate checks in place so that the algo performs in a controlled manner. All algos developed by any entity have to run on the servers of broker wherein the broker has control of client orders, order confirmations, margin information among others.

Sebi suggested that brokers can either provide in-house algo strategies developed by an approved vendor or outsource the services of third party algo provider/vendor. Stock brokers should be responsible for all algos emanating from its APIs and redressal of any investor disputes.

The regulator said that obligations of stock broker, investor and third party algo provider need to be separately defined. Stock broker is responsible for assessing suitability of investor prior to offering algo facility.

"No recognition shall be given by the exchange to the third party algo provider/vendor creating the algo," Sebi said. The regulator proposed that two factor authentication should be built in every such system which provides access to an investor for any API/algo trade.

The Securities and Exchange Board of India (Sebi) has sought comments from public till January 15 on the proposal.

According to Sebi, there needs to be a clarity on whether the services offered by the third party algo providers are in the nature of investment advisory services as the nature of their services includes providing strategies to the investors based on research and analysis done by them.

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 service, it added.

(With inputs from agencies)

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