SEBI's Proposal on Algo Trading and associated concerns

Context: Recently, the Securities and Exchange Board of India (SEBI) has issued a discussion paper on regulating Algorithmic or Algo Trading, or trades generated out of automatic execution and logic.
Key Features of Algo Trading 

Algo trading refers to orders generated at superfast speed by the use of advanced mathematical models that involve automated execution of trade.

• First, the algo runs on the broker’s systems and not on the investor’s system. 
• Secondly, algo trading requires no human involvement from either the broker or the investor. 
• Thirdly, the algo trading system automatically monitors the live stock prices and initiates an order when the given criteria are met. This frees the trader from having to monitor live stock prices and initiate manual order placement.
• The algo trading system automatically monitors the live stock prices and initiates an order when the given criteria are met.

What is API?

• API stands for Application Programming Interface. It is a program that establishes an online connection between a data provider and an end-user.

What role does API play in trading?

• APIs have become increasingly popular with the rise of automated trading systems. In the past, retail traders were forced to screen for opportunities in one application and separately place trades with their broker. 
• Many retail brokers now provide APIs that enable traders to directly connect their screening software with the brokerage account to share real-time prices and place orders.

What are SEBI’s proposals on Algo Trading?
There is a need to create a regulatory framework for algo trading.

• For this, all orders emanating from an APIs (Application Programming Interface) should be treated as an algo order and be subject to control by the stockbroker.
• APIs carrying out algo trading should be tagged with the unique algo ID provided by the stock exchange.
• All algos developed by any entity has to run on the servers of brokers, wherein the broker has control of client orders, order confirmations and margin information.
• The stockbroker is responsible for all algos emanating from its APIs and redressal of any investor disputes.

What are market concerns against these proposals?
Securing exchange approvals for any algo is already an extremely tedious and complex process. If these proposals are implemented, brokers will have to stop offering APIs and might shift to some other system.

• Risk To Market: Unregulated and unapproved algos pose a risk to the market and can be misused for systematic market manipulation as well as to lure the retail investors by guaranteeing them higher returns.
• Identity Issue: Currently, exchanges approve algos submitted by brokers. However, for algos deployed by retail investors using APIs neither the exchanges nor the brokers can identify if a trade emanating from the API link is an algo or a non-algo trade.
• No Redressal Mechanism: Potential losses in case of a failed algo strategy could be huge for retail investors since third-party algo providers are unregulated and there is no investor grievance redressal mechanism in place.

Key Significance

• Protection of Retail Investors: It will ensure that the interest of retail investors is protected and it will boost investors’ confidence to undertake algo trading.
• Curb on Price Manipulation: With a set of rules in place, there won’t be any price manipulations and the investors will not incur any heavy losses in the process.
• Empowerment of Brokers: Additionally, it might be a blessing in disguise for brokers to scale up their technological prowess and expand their clientele.