SEBI Proposes Broker Responsibilities For Investor Participation In Algo Trading

The market regulator, SEBI, has put out a draft circular for better oversight of retail investor participation in algorithmic trading.

Under the new proposal circular, brokers providing algo trading facilities must stick to existing rules and obtain the necessary approvals from stock exchanges for each algorithm used. 

These brokers are required to tag all algorithmic orders with a unique identifier, enabling traceability and an audit trail. Any changes to approved algorithms or trading systems must be cleared by the relevant exchange.

Brokers will also play a critical role in the use of application programming interfaces (APIs) for algorithmic trading. In these cases, brokers will act as the principal party, while third-party algo providers will act as their agents. 

Moreover, any algo orders exceeding a specified threshold will need to be tagged with an identifier provided by the exchange to differentiate them from regular orders.

For the first time, the proposal also allows retail investors with programming skills to develop their own algorithms. These self-developed algorithms must be registered with the relevant stock exchange through a broker. The registered algorithms may also be used by the investor's immediate family, which includes spouses, dependent children, and parents.

To ensure security, brokers are mandated to implement robust systems to identify and categorise all algo orders above the specified threshold. They are prohibited from offering open APIs and must use secure, vendor-specific API keys with static IP addresses for traceability. Brokers are also required to implement two-factor authentication for accessing APIs.

SEBI’s new proposal also outlines the role of algo providers. Any provider facilitating algorithmic orders through APIs will need to be empaneled with stock exchanges, subject to eligibility criteria specified by the exchanges. The exchanges will also have the responsibility to oversee and inspect the operations of brokers and ensure that they comply with the updated regulations.

Stock exchanges will maintain the ability to monitor post-trade activities, including using a "kill switch" to halt trades originating from malfunctioning algorithms. Additionally, exchanges will be tasked with defining the roles and responsibilities of brokers and algo providers, including the risk management systems that brokers must establish.

The proposal introduces a distinction between two categories of algorithms: Execution Algos (also known as White Box Algos) and black box algorithms.

Execution algorithms are transparent and replicable, allowing users to understand the logic behind the trades. Black Box algorithms, on the other hand, are not transparent, and the logic governing them is not accessible to the user.

For Black Box algorithms, the algo provider will need to register as a research analyst and maintain a research report for each algorithm. If the logic of the algorithm changes, the algo must be re-registered, and a new research report must be provided.

The proposed changes will come into effect in 2025.

To support the implementation, stock exchanges are required to establish the necessary systems and procedures. In consultation with SEBI, the Broker’s Industry Standards Forum will develop pilot standards to guide the implementation process.

Exchanges will also be responsible for informing their brokers about the new guidelines and updating their rules and regulations accordingly.