SEBI has introduced a regulatory framework to facilitate safer participation of retail investors in algorithmic (algo) trading. This circular refines existing regulations to ensure adequate checks and balances, safeguarding investor interests and maintaining market integrity. The framework clarifies the roles and responsibilities of key stakeholders, including investors, brokers, algo providers/vendors, and Market Infrastructure Institutions (MIIs).
Key Highlights:
1. The Need for Regulation:
- Algo trading automates order execution using pre-defined logic and offers advantages like timed execution and precision.
- While institutional investors have long used Direct Market Access (DMA) for algorithmic trading, retail demand for algo trading has increased.
- SEBI aims to regulate retail algo trading by defining responsibilities for brokers and exchanges while ensuring investor protection.
. Role of Brokers in Algo Trading:
- Brokers will act as the principal and algo providers/vendors as their agents while using APIs for algo trading.
- API-based trading safeguards:
- All algo orders must be tagged with a unique identifier provided by stock exchanges.
- Retail investors who develop their own algos (using coding knowledge) must register them with the exchange if they exceed a specified order-per-second threshold.
- Such algos can only be used for self and family, not for other investors.
- Brokers must ensure:
- Detection and categorization of orders exceeding the threshold as algo orders.
- No open APIs – Access is granted only via a unique vendor-client API key and a whitelisted static IP.
- Authentication via OAuth-based security and two-factor authentication.
- Handling of complaints related to algo providers, as they act as agents of the broker.
3. Regulatory Framework for Algo Providers:
- Algo providers will not be regulated by SEBI, but:
- They must be empaneled with stock exchanges based on criteria defined by exchanges.
- Brokers must conduct due diligence before onboarding algo providers.
- Subscription charges and brokerage fees may be shared between brokers and algo providers, provided full disclosure is made to clients.
- Brokers must ensure that revenue-sharing arrangements do not create conflicts of interest.
4. Role of Stock Exchanges:
- Exchanges will supervise and regulate algo trading, ensuring:
- Standard Operating Procedures (SOPs) for algo testing.
- Surveillance and simulation testing of algos.
- The ability to use a kill switch for malfunctioning algos.
- Brokers must differentiate between algo and non-algo orders.
- Confidentiality of retail algo strategies will be protected via:
- Confidentiality clauses
- Non-disclosure agreements (NDAs)
- Encrypted submissions
- Stock exchanges must establish fast-track approval for simple execution algos.
5. Categorization of Algos:
SEBI defines two categories of algos:
- Execution Algos (White Box Algos) – Transparent, where the logic is disclosed and can be replicated.
- Black Box Algos – Proprietary algos where the logic is hidden from the user.
- Black box algo providers must register as Research Analysts and maintain detailed research reports.
- If an algo’s logic changes, it must be registered as a new algo.
6. Implementation & Compliance Timeline:
- The Broker’s Industry Standards Forum (ISF) will finalize implementation standards by April 1, 2025.
- Full compliance will be mandatory from August 1, 2025.
- Exchanges must:
- Amend bye-laws, rules, and regulations accordingly.
- Inform brokers and disseminate guidelines on their websites.
7. Broker Responsibilities in Risk Management:
- Brokers must obtain exchange approval for each algo before allowing clients to use it.
- All algo orders must be auditable and maintain a clear order trail.
- Brokers must handle investor grievances related to algo trading.
- APIs must be monitored to prevent prohibited activities.
Conclusion:
SEBI’s new regulatory framework enhances transparency and accountability in retail algo trading by clearly defining stakeholder roles. It ensures that:
- Retail investors can safely participate in algo trading under structured regulations.
- Brokers take full responsibility for algo trading facilitation, due diligence, and investor protection.
- Algo providers are brought under indirect oversight via empanelment with exchanges.
- Exchanges maintain their role in market surveillance and risk management.
By implementing these checks and balances, SEBI aims to make algo trading safer, more transparent, and structured, benefiting both investors and market participants.
Read the whole circular here.