In today’s Finshots, we break down SEBI’s idea of letting retail investors use algo trading in a more regulated setup.

The Story

India has nearly 10 crore retail investors. That’s one in every five households across the country!

Many of these investors are everyday folks like us, juggling full-time jobs. So while the stock market might lure us with the prospect of making some cool profits, keeping track of price tickers all day is tough and sometimes even impractical. That could often mean higher chances of losses or stepping away from markets altogether.

Enter algorithmic trading, or algo trading, which is a game-changer for situations like these. Think of it like having a computer trade for you. You set rules for price, timing and volume, and it executes trades automatically. For instance, if you’re interested in textile stocks, you could program an algorithm to buy stocks in this sector when prices rise 5% over a week, assuming that demand is strong, or sell when they drop by 5%. The best part? You don’t have to stay glued to the screen. It’s all automated.

But here’s the thing. Despite all the buzz around algo trading, Indian retail investors have largely been left out of it. That’s because institutional investors have enjoyed greater freedom since algo trading launched in 2008. But retail investors only got a set of these regulations in 2021. These rules placed the responsibility for algo trading on brokers, meaning retail investors had to rely on pre-built algorithms provided by brokers, which were executed exclusively on their servers.

And this setup wasn’t ideal. Just think about it. A glitch in the broker’s system, a loophole in their strategy or even manipulation from their end could lead to massive losses for retail investors. Unregulated algo providers also offered risky services, leaving investors with no way to address grievances. SEBI seemed to catch on to these problems and naturally it cracked down.

But it didn’t stop there. It also realised that simply clamping down on algo trading wasn’t the solution. It needed to go a step further, regulate the space and take charge of overseeing it.

And there’s enough reason that nudged it to think on these lines. A recent study revealed that individual traders lost over ₹61,000 crores in the equity F&O segment in FY24, while large entities using trading algorithms, like proprietary traders and foreign investors, walked away with gross profits of ₹33,000 crores and ₹28,000 crores, respectively.

Clearly, retail investors were fighting a losing battle against sophisticated algorithms. And that’s exactly why SEBI is now working to make algo trading more accessible to retail investors, in a safer and well-regulated environment.

And SEBI’s suggestions are simple.

It proposes tagging orders exceeding certain speed or volume as algo orders. Then, it requires brokers to get stock exchange approvals for any algorithm they offer. Third-party algo providers will act as agents of brokers and must also meet eligibility criteria and register with stock exchanges.

Then, SEBI splits these algorithms into two types. First up, there are White Box Algos that are fully transparent. Here, investors can see and understand the logic, like say, an algo that buys shares when a stock hits ₹100. And second, we have Black Box Algos, where the investors don’t really know how the algorithms work internally. Such algos are opaque and therefore providers must register as “Research Analysts” and submit detailed reports for these to stock exchanges.

Exchanges will also supervise algo trading and ensure everything runs smoothly.

So stock exchanges will now have to have a rule book to test algorithms. Basically, rules so that stock brokers can verify how these algos would have performed using past data. This helps traders figure out which parts of their system work and which don’t. It also allows exchanges to ensure that brokers submitting algos for approval are ironing out any flaws beforehand.

Besides, if an algo goes rogue, it prescribes a kill switch mechanism or a kind of emergency brake tool. If an algorithm malfunctions, the kill switch can instantly halt trading to minimise damage. Think of it as the last line of defence, kicking in automatically based on pre-set conditions.

So yeah, with these measures, SEBI wants to make algo trading safer, hold brokers accountable and protect retail investors like us from unnecessary risks.

And these regulations are actually an upgrade from their 2021 version.

Back then, SEBI suggested that all orders coming through an API i.e. Application Programming Interface, or a bridge that allows different software to communicate, should be treated as algo orders. Because frankly, neither exchanges nor brokers could differentiate between algo trades and non-algo trades if they came through an API link. But here’s the thing. APIs are everywhere! Even the trading apps you use to log in or place simple limit orders (orders at a specific stock price) rely on APIs. So treating every API order as an algo trade would have been quite overboard and could have slowed down tech advancements designed to make trading easier for investors.

SEBI seems to have realised this and tweaked its stance. Its new approach focuses on speed and volume thresholds instead. So now, only orders exceeding a certain speed or volume threshold will be treated as algo trades.

And this thoughtful regulation could transform India’s markets for the better. For context, today, around 50% of traders in India use algorithms, compared to 60–70% in markets like the US and Europe. And making algo trading more accessible could bring more accurate and cost-effective trades.

Moreover, algorithms can analyse and execute trades at lightning speed and eliminate emotional biases like fear or greed that we humans have, reducing the chances of poor decisions. So yeah, this truly feels like a step forward.

It’s not all smooth sailing, though.

One potential hurdle lies in the requirement for stock exchanges to approve every trading algorithm. According to the Indian Association of Investment Professionals, a similar rule in SEBI’s 2021 regulations could make things tricky. Because trading strategies need to adapt quickly to changing market conditions. And by the time an exchange approves a strategy, it might already be outdated and the trading opportunity could slip away.

So this time, SEBI has suggested fast-track registration for certain algos, aiming for quicker approvals. But the turnaround time is still up to the exchanges, so we’ll have to see how well it works in practice.

And even with these regulations, algo trading isn’t immune to Black Swan events — those rare, unpredictable shocks. Take the example of textile stocks we mentioned earlier. If an algo is programmed to buy when prices rise 5% in a week, an unexpected event, like the Bangladesh crisis pushing textile stocks up by 20% overnight, could throw it off. The algorithm might be in a situation where it’s unable to handle such wild swings and end up buying or selling at the wrong time, causing poorly timed trades and huge losses.

That’s where stock exchanges could step in. If they not only back-test algorithms with past data but also stress-test them for extreme scenarios, much like they do with equity derivatives like F&O, it could reduce risks and improve preparedness.

For now, though, these rules are just part of a consultation paper SEBI floated last week. And we’ll only have to wait and see how things shape up after the feedback rolls in.

Until then…

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