What Sebi’s taming of algo trading means for the market

Institutional investors, with their deep pockets, have for years been using algorithmic trading and high frequency trading.
Institutional investors, with their deep pockets, have for years been using algorithmic trading and high frequency trading.


  • Sebi is cracking the whip on algo trading to protect retail investors. But will it thwart market evolution?

MUMBAI : Talk of eye-popping returns. Here’s what they look like.

Till last week, ‘Index Premium Eater’ advertised a return on investment (ROI) of 60.81% in the last one year; ‘Banknifty Fighter’ an ROI of 49.73%; ‘Index Volatile Vaccine’ a more moderate 34.63%.

The three are trading strategies on offer at algo strategy marketplace TradeTron. They all carry a disclaimer when you read the fine print.

The strategy of Index Premium Eater, which is based on options selling, has been created by an entity called MarketStar on the marketplace. It is not a Securities and Exchange Board of India (Sebi)-registered investment firm or financial advisory. Similarly, Banknifty Fighter is created by Algo Wise. “I am not Sebi registered analyst. No claims, rights reserved. I am not responsible for your profit or loss," the entity discloses. Soon after the risk disclaimer, comes three words in a bigger font and in caps: ‘MAKE MORE MONEY!!!’.

Algo Wise has 8,102 subscribers on TradeTron; MarketStar three times the number. We can assume that thousands of other investors are following many such curated automated trading strategies—retail algos allow retail investors to use an algorithm or computer programme to set ‘buy’ and ‘sell’ criteria for stocks. The programme automatically generates orders, which are next sent to a broker and, at times, even sent to the stock exchange directly.

The NSA treading mode
View Full Image
The NSA treading mode

Many also assume that algo trading democratizes the stock market. Institutional investors, with their deep pockets, have for years been using algorithmic trading and high frequency trading. This places them at a distinct advantage as they can capitalize on the milliseconds saved in executing large orders. However, for the retail investors, there are the hidden risks of mis-selling as well as technological bottlenecks. These risks were largely ignored in the last two years of the bull run.

Now, Sebi, India’s market regulator, is cracking the whip.

In December last year, Sebi issued a discussion paper to formulate a comprehensive framework for retail algo trading. The rules are yet to be drafted. On 2 September this year, a circular flagged rampant advertising of past returns and profits.

“It has come to the notice of Sebi that some unregulated platforms are offering algorithmic trading services/ strategies to investors for automated execution of trades. Such services and strategies are being marketed with claims of high returns on investment. Further, ratings have been assigned to the strategies, which could lead to investors being lured by such claims. This may amount to mis-selling of such services and strategies to investors," the regulator stated.

It directed stock brokers to stop making any direct or indirect reference to past or expected future return and disassociate from platforms that make such references.

Subsequently, TradeTron sent an email to all its broker partners stating that it is removing references to ROI, rating and statistics information from the strategy pages. The marketplace, however, did not respond to e-mailed clarifications sought by Mint.

These are early days in Sebi’s attempt at regulating automated trading. This isn’t an easy job—we will tell you why. But first, a peek into the growing retail interest in trading itself.

The rise of retail

Retail investors flooded India’s stock markets during the first two years of the pandemic. Here, too, the numbers are eye-popping.

As of August 2022, the number of demat accounts, one that helps investors hold shares in an electronic format, have risen to 100 million. Along with regular cash trading, many first-time investors started dabbling in equity derivatives trading. As the name suggests, this instrument derives its value from an underlying stock. It is an agreement between parties to buy or sell shares in the future. Gains are made by estimating the future value of the shares. Then, there is options trading, a variety of equity derivative that gives the trader the right to buy or sell a specific security on a specified date and price. The index options trading on the National Stock Exchange (NSE) touched historic highs at the end of August, with some broking houses posting a 20-30% rise in derivatives volumes.

According to brokerage firms, many retail investors are using algo trading strategies for options trading. On the NSE, only 18.41% of trading is non-algo. For BSE, 35.45% trading is non-algo. But these numbers also include institutional trading.

When did retail investors begin using algo trading strategies?

One inflection point was in 2017 when discount brokerages such as Zerodha, Upstox and 5paisa started offering algo trading solutions tailored for retail investors. What separates retail algo from institutional algo is ‘co-location’—the big boys of institutional investing can buy rack space within stock exchange premises to reduce the lag in getting market data and executing orders.

Nearly 80 brokers are currently providing a mechanism to execute algo trades. “For top brokers, about 1-2% of their turnover is generated from retail algo users. Overall, retail algo trading market share would be about 5-6%," said the CEO of a discount brokerage firm who didn’t want to be identified.

“Percentage-wise, the number might be small. But, absolute numbers are large. This has forced the regulator to work on a framework. Between July 2020 and June 2022, an estimated one million retail investors tried algo trading," said a senior regulatory official who didn’t want to be identified as well.

Nuances of the trade

Algo trading appears simple for the investor but at the backend, it is anything but straightforward. Here’s how it works.

There are three key players—the retail investor, the trader or the strategy provider (like MarketStar and Algo Wise mentioned earlier), and the brokerages. Retail investors seek and pick the algo trading strategy from traders and the orders are next executed by the brokerages.

Every broker has an open Application Programme Interface, or API. This is a plug and play system that allows a trader’s software to connect to the broker terminal. Brokers, at their end, have an order management system which is used to place an order electronically.

The customization for automated trading is done by the trader’s software. A simple customized algo command could be something like this: ‘Buy 100 shares of Reliance Industries if the price falls to 2,000’. This algo would generate a trade instruction for the brokerage to execute the trade.

“If someone does want, they can devise their own trading strategy and plug into FYERS API to execute their strategy. Much of the retail algo trading market is with us. Overall, the market is still very nascent. Perhaps in single digits (as percentage of total trade volumes)," said Tejas Khoday, co-founder and CEO of FYERS, a discount brokering firm.

While brokerages have been providing simple tools to investors to execute such automated trades, things are a tad more complicated now because of the mushrooming of algo strategy marketplaces. Besides, TradeTron, there is AlgoBaba, Algoji and AlgoBulls. As mentioned earlier, these marketplaces host strategies from third parties.

In many cases, software engineers and those with programming skills write the algo strategies, said industry insiders. We don’t know if the engineers have any understanding of the markets. The risks for a retail investor blindly subscribing to such strategies are, therefore, high.

The strategies are often written and analyzed by the concept of ‘backtesting’—it is about analyzing past historical financial data to generate a set of trading signals. There are three problems with the approach.

One, bulk of the backtesting today is based on data analyzed over the last two-three years. The last two years saw an exceptional bull run, which means that every algo strategy looks attractive. Two, past performance cannot guarantee future returns. Three, the strategy writers and the marketplaces remain unregulated as of now.

“There is over-marketing of performance and returns. What worked in the past cannot, for sure, work in the future," said Kunal Nandwani, co-founder and CEO of Utrade Solutions Pvt Ltd, a fintech company providing algo engines.

TradeTron, like the traders on its marketplace, publishes a disclaimer on its website: “Indian laws require portfolio managers and investment advisory service providers to be registered under Sebi. US laws do not have any such requirement as long as the advice is not client specific".

The company further states: “In any case, responsibility to be registered, if required, to conduct the portfolio management business lies with the strategy creator and investors are advised to check the credentials of the portfolio managers before investing. All due diligence before investing in any strategy is the responsibility of the user and Tradetron Inc assumes no part in it as it’s a neutral technology service provider facilitating the engagement of traders with portfolio managers and not a financial services provider itself".

TradeTron’s registered office is in San Jose in the US but the company has a development centre in Mumbai.

Sebi’s diktat

On 2 September, India’s market regulator made it clear that it wants to stop the rampant advertising of past returns and profits.

After Sebi directed stock brokers to disassociate from platforms that make reference to past or expected future returns by 9 September, there is a visible reduction in such advertising. But, the problem persists. The Telegram channels of strategy writers continue to advertise their profit and loss metrics.

On their websites, every marketplace advertises the broker partners, which brings them legitimacy. TradeTron, for instance, has 69 broker partners.

“Well governed brokers were anyway not advertising such performances. Many discount broking firms had asked marketplaces to remove their names from the latter’s website. We will once again send reminders," the CEO of a second discount broking firm said.

Sebi has now asked the exchanges (who are supposed to monitor broker compliance) to ensure that the circular is implemented in letter and spirit and a report submitted within 60 days. Cases of non-compliance will attract penal action.

The regulator appears to be worried about both the technological risks as well as unqualified advisors.

“Sebi is still concerned about fat finger trades and algos misfiring. These can lead to systemic risks," said Khoday. Fat finger trade is a human error while punching an order. This can include entering a wrong value in terms of price or quantity or even selection of the wrong execution action such as buy or sell.

“For us, it is easier to pass directions to regulated entities rather than to unregistered platforms. Which is why we are asking for a complete dissociation," said the regulatory official quoted above.

By the end of this year, Sebi wants to have in place a comprehensive algo trading framework. It could largely be on the lines of the discussion paper brought out in December. But this worries market participants.

Fears surface

In the discussion paper, Sebi bracketed all APIs as algo—in the future, they could require exchange approval. Sebi also wants all the strategies to be approved by the exchanges and brokers. This means that even the slightest tweak in an algo would require approval by both the entities.

“APIs are not algos. API is a software language connecting brokers with the trader’s software. These can be audited. There are millions of algos generated by traders. If all these algo strategies require an approval from the exchanges, it would choke the process," said the first discount broking CEO quoted earlier.

Typically, a brokerage has little control on who uses its API. “We cannot track whether the trade directions are coming from a regulated/ unregulated entity or from an individual trader. It is tricky. The Sebi paper also lays complete onus on brokers to validate and monitor algo strategies, which is next to impossible. It will increase compliance costs exponentially," the second CEO said.

Yet another concern is around intellectual property (IP). If third party tech platforms and traders need to share their algo with brokers for approvals, there is a possibility of the IP being compromised—some brokerages can easily replicate the successful algo strategies.

“If the circular issued on 2 September was the only framework, we could have lived with it. But the indication that more regulations are in the offing will be detrimental to the market. It will curtail trading activity of savvy and informed investors, too," the CEO said.

Sebi, therefore, has a tough road ahead. It needs to manage the risks of mis-selling while ensuring that innovation and market evolution isn’t stalled. That’s a delicate balance.

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.



Switch to the Mint app for fast and personalized news - Get App