Co-authored with Raghuvamsi Meka, Senior Associate and Parker Karia, Associate, Finsec Law Advisors
The Securities and Exchange Board of India (Sebi) recently issued a circular addressed to stock exchanges and brokers in relation to performance/return claimed by unregulated platforms offering algorithmic (algo) strategies for trading.
Inits circular, the regulator notes that algorithmic trading services and strategies are being offered to investors for automated execution of trades andare marketed claiming high returns on investment, by various unregulated platforms. Some of the algo strategies are even assigned ratings, which Sebirightly believes to constitute mis-selling of services and strategies to unsuspecting investors. Sebi has further noted that in certain instances, stockbrokers are providing algorithmic trading facilities through such unregulated platforms.
Inview of the risks associated, with the lack of adequate investor protection and grievance redressal mechanisms, the regulator has mandated that stock brokers providing algo trading services shall neither make any direct or indirect reference to the past or expected future returns or performance of the algorithm, nor shall it associate with any platform providing such references.Offering a week’s time to comply with the above, the circular instructs stock exchanges to ensure compliance of the above by the stock brokers by i) making relevant amendments to its bye-laws, rules and regulations; ii) disseminating the information to brokers; and iii) by submitting a compliance report within 60 days of the circular.
Sebi’s previous warnings and proposed framework
This is not Sebi’s first attempt to regulate algo trading. In June, it cautioned investors against falling prey to algo trading services and strategies offered by unregulated platforms. In December 2021, it proposed a framework for algo trading by retail investors, which sought to address the rise in the use of Application Programming Interface (API) access, which inter alia allow for automation of trades. These APIs are used to establish a connection between the trader and the broker, to obtain real-time quotes and pricing data, and also enable traders to use a third-party application to place orders in the market which may or may not be based on an algorithm. Sebi’s concern with the use of APIs was that orders coming via these are not subjected to any scrutiny, and whether there is an algo behind the API can’t be determined. Thus, it was proposed to treat all orders emanating from APIs as algo orders, requiring appropriate tagging and certification.
The proposed framework was flawed, as the classification of all API trades as algotrades was inaccurate and unfair, and the regulator’s proposal would have contributed to the contraction of the booming API industry. Further, the proposed framework imposed a heavy burden on stock brokers, and did not take into account the nature of algo strategies.
Concerns with the current approach
Itis clear that Sebi’s core concern with algo trading appears to the mis-selling of algo services and strategies, especially in view of the quoting of past performances, prediction of future performance and assignment of ratings. While such marketing tools can lure unsuspecting or unaware investors, the regulator appears to ignore the fact that quoting past performances is not an uncommon practice in the securities market. For instance, mutual funds routinely quotepast returns as an indicator of the success of the fund.
Another way to look at this is: On what parameters would an investor ascertain whether a particular algo strategy or service would be appropriate for the concerned investor? Sebi’s move will essentially retard the algo trading industry, as investors have been deprived of a viable metric to ascertain which algo service or strategy is appropriate. Unable to ascertain the benefits of the algoservice or strategy, or compare various algo strategies, investors may refrain from availing algo services.
Algostrategies offered by stock brokers through third-party platforms, orotherwise, would have been duly approved by the stock exchanges, and necessaryinternal controls to mitigate risks would be in place, among various othersafeguards and conditions. By prohibiting stock brokers from advertising thepast performance data of the algo strategies, Sebi may be unintentionallyherding the investors to the dark (unregulated) side, which may continue toprovide performance indicators. It is also important to note that pastperformance may or may not be an indicator of future success. In fact, that iswhy such performance indicators are accompanied with disclosures anddisclaimers, as in the case of mutual funds.
Instead of the practical ban on algo trading, in order to mitigate the risks, the regulator could have mandated that all performance indicators be accompanied with appropriate risk disclosures. Guidelines in relation to the manner in which past performance should be gauged can be framed as well, considering the atypical nature of algo trading.
Interestingly,Sebi does not seem to be in a hurry to pursue the most viable approach (whichit suggested in its consultation paper), i.e., to bring algo strategies under the ambit of investment advisory. In its consultation paper, the regulator had admitted that there isn’t sufficient data to ascertain whether providing algo strategies comes under the scope of an investment adviser. However, quite sometime has elapsed since then, suggesting that at least preliminary data would be available to adopt a more practical approach. Bringing algo providers under the Sebi laws on investment advisers or research analysts, with suitable modification to existing rules, could help regulate their practice and restrict mis-selling of algos, while appropriately distributing the compliance burden amongst the market participants, including the regulator. In the US, members are required to register associated persons who are primarily responsible for the design, development or significant modification of ‘algo trading strategies’ (or for day-to-day supervision or direction of such activities) as‘Securities Traders’.
In the longer run, a regulated registration requirement would go a much longer way in ensuring accountability, investor protection, grievance redressal and a minimum standard of training and awareness as opposed to the latest step taken by Sebi, which looks like a stop-gap measure with potential to create an existential threat to the algo market and be counterproductive in its stated aim of investor protection. Be it a separate regulation or inclusion of algo traders within the scope of investment advisers, Sebi needs to come up with a comprehensive policy to address the concerns of all stakeholders and balance the interests of all parties in the algo trading space—sooner rather than later.
(This article was first published in Financial Express)