SEBI’s Rules to structure Retail Traders.
Algo Trading Specifics
API Application Programming Interface is a computer programming approach for facilitating the exchange of information and executing instructions between different computer systems. Open APIs refer to APIs that allow third-party access to the systems of an organization.
Open API lets banks share their computer systems and information with outside companies or other banks in a clear and organized way. This helps improve how customers interact with their banking services.
What is an open API?
This is basically a bunch of code that helps to analyze data and pass messages between different software systems. So imagine when you're using an app to trade stocks. This code helps connect your app to the broker’s system smoothly.
When people place orders through this system, like buying or selling stock, the broker and the stock exchange can't really tell if the orders were made by a computer programmer or by the person placing the orders.
The SEBI now makes sure that brokers offer open Application Programming Interfaces (APIs) to regular customers only if they know whether the API is being used for automated trades or manual ones. If the broker isn't sure, they shouldn't allow the client to use the API.
Is Algo trading for retail investors?
It largely depends on the strategy being followed. A handful of retail traders may win, but the vast majority are no match for quant firms that spend a fortune on hiring the best talent available and invest heavily in state-of-the-art hardware. In algo trading, accuracy is a must. According to one of the known industry observer, if you're really into algorithmic trading, it's crucial to have a server located close to the exchange servers. That's because, most of the time, being faster than the competition is the key to success. It's like going into a serious competition with just a basic tool when your opponents are armed to the teeth.
A handful of traders who know how to write software code devise their own strategies. But a vast majority buy them from third-party service providers. Traders using their own strategies will need to tell brokers about the algo strategies. Organizations using algo trading have to make their algos known to stock exchanges; there is no reason why retail traders should be treated any differently.
Algo trading
It's the automated use of algorithms to generate trading signals and execute buy or sell orders with the broker.
It has been used to improve profit-making potential and minimize human errors.
Developed markets like the US contribute approximately 70–80% of the equity market turnover. India has surged now in algorithmic trading, accounting for over half of the total trading activity, a significant leap from just 9% back in 2010.
Algorithmic trading involves smooth transactions to recognize when investors enter and exit trades. The absence of human interference makes time and extends the chances of traders.
On that note, let's understand the concepts, strategies, advantages, and consequences of algo trading.
How are algo strategies used by retail traders?
The trader gives their login details for their trading account to the person who created the algorithm. then that person uses the trader's account to make trades.
The algorithm creator provides a programme that the trader installs on their computer.
The trader connects their trading account to the creator’s website and picks from the different strategies available. They don’t need to share their login details with the creator in this case.
Criticism against third-party providers of algo strategies
Less-known strategies work well. The more well-known a strategy becomes, the less effective it will be in generating profits. The commercial market seldomly delivers good returns consistently.
SEBI’s Concern
Most of the Algo developers promise huge returns to traders. Two algo developers are passing rules applicable to registered investment advisors (RIA) as mandated by the regulator. The developers have been avoiding coming under Sebi's scrutiny by arguing that they shouldn't be registered since it's the software that's producing the signals. However, it's the developers who are making lofty promises to clients, which directly breaks Sebi rules. Selling basic strategies to retail traders while giving them the intuition that they are extraordinary and asking for heavy fees. There are also allegations of back-testing results.
Simply put, what is being packaged as a ‘savory harmonious medley of aromatic rice and lentils with a garnish of cilantro’ is nothing but plain dal khichri.
Many algo developers have been accused of showing good returns and are not trustworthy. That is because the developer may have cherry-picked certain time periods and also fine-tuned the trading strategy so that it fits the historical price pattern.
An open API is offered only to clients, so the broker can be certain if it is being used for algo trades or non-algo trades. Who is using their API and for what purpose must be regulated to keep the brokers on the safe side? In April 2016, the US Securities and Exchange Commission (SEC) approved a rule proposed by the Financial Industry Regulatory Authority (FINRA) requiring algorithmic trading developers to register as securities traders.
SEBI’S take on Brokers
SEBI wants to ensure that brokers are aware of who is using their API and for what purpose. For brokers, algorithmic trading means more money through fees, better services for clients, and more opportunities to sell additional products. It makes the market work smoother for everyone involved.
Brokers will then work with only those developers who will be transparent about their activities. By this technique, gradually, some developers are under watch.
Such a move will also reduce mis selling to a significant extent. The back testing results will have to be confirmed by independent acceptance agency SEBI to ensure this. This will give a better picture of the effectiveness of the strategy.
Brokers benefit from their clients' algorithmic trading in several ways:
More Trades, More Earnings: Algorithmic trading, especially high-frequency trading, means lots of transactions happening quickly. This means more commissions and fees for brokers.
Help with Trading Tech: Brokers provide the tools and technology for algorithmic trading. They offer platforms, connections to exchanges, and APIs so clients can trade smoothly. These services come with fees.
Access to Market Info: Algorithmic traders need loads of market data and research tools. Brokers offer these resources for a fee, helping traders make informed decisions.
Personalized Help: Brokers often provide support and customization options for algorithmic traders. They help with strategy development, optimization, and troubleshooting; they charge for these services.
Boosting Market Activity: Algorithmic traders constantly place buy and sell orders, adding to market liquidity. This helps brokers by improving trade execution for everyone.
Keeping Risks in Check: Algorithmic trading has its risks, like market fluctuations or technical glitches. Brokers provide tools to manage these risks, like checking trades before they happen or monitoring positions in real-time.
Opportunities for More Sales: Algorithmic traders might need more than just trading help. Brokers can offer them other financial products, like investments or wealth management services, increasing their revenue.
Algorithmic trading comes in different forms:
Ready-made templates: Some companies offer pre-made templates that traders can use on their platforms.
Third-party offerings: Other algos are created by outside developers and offered on shared platforms.
Custom-made: Traders can also have items tailor-made to suit their specific needs.
But there are concerns, especially from regulatory bodies like SEBI (Securities and Exchange Board of India). One worry is that some algo developers make big promises of profits to attract unsuspecting traders. Another issue is that these developers often skirt regulations meant for investment advisors by claiming it's the software, not them, making the decisions.
However, this argument doesn't hold up. While the software executes the trades, it's the developers who set the rules and make the promises, thus falling under regulatory oversight.
Aside from false promises, there's also the problem of misrepresentation. Some algo developers sell basic strategies as something exotic, charging high fees for what essentially amounts to plain trading strategies.
Furthermore, there are doubts about the reliability of the back-testing results provided by many algo developers. They may cherry-pick data or tweak their strategies to fit historical patterns, making their past performance look better than it actually is.
Brokers can benefit from their clients using algo trading in various ways. For instance, some developers have deals with brokers where they get a cut of the commission if their clients trade through that broker.
There's also the risk of algo trading causing large price swings if something goes wrong. While institutional assets are typically vetted by exchanges, those used by retail traders often aren't, posing a potential risk to the market.
To address these issues, SEBI is proposing measures to bring more transparency to algo trading. They want brokers to provide open APIs (application programming interfaces) only to clients using algos, ensuring they know who's using them and for what purpose. Additionally, SEBI suggests that back-testing results should be verified by independent agencies rather than relying solely on developers' claims.
Overall, these moves aim to make algo trading safer and more transparent for all involved.
