Gupta ji is a stock market trader. He has lost his lifetime savings in F&O trade. He sold his house to settle the F&O Bill and moved to a rented house. He is still hopeful. SEBI’s proposal to allow algo trading to retail investors has raised his hopes high. He feels that computer will make money for him throughout the day. Computer means flawless and emotionless decision making. Is Gupta ji right in his approach? Let us try to analyze Algo trading system in detail.
ABC of Algo trading: Algo trading is an automated trading system. Generally, you place buy/sell order either yourself or through your dealer. In algo trading, buy/sell orders are placed by the system itself. For example, a share XYZ is trading at Rs 100 at BSE and the same share is trading at Rs 100.50 at NSE. You can buy the share at BSE and sell at NSE. Through this trade you will pocket 50 paisa in each trade. This trade involves three legs. One, identifying a share which is trading at different rates at BSE/NSE at a given time. Finding the share with maximum price differential is the key to success. Two, taking BUY trade at lower price and SELL trade at higher price. Three, taking trade at a faster speed because more the number of trades, higher the profit. A computer program can be written in a way which will identify shares with highest differential, initiate trades and generate profit. This computer program will be named as an Algorithm (Algo). This is a simple Algo based on arbitrage. Cash to cash, Cash to derivative, derivative to derivative arbitrage are examples of simple Algo.
Types of Algo: Algo are of two types: White Box Algo and Black Box Algo. As the name suggests, White Box Algo is a transparent algo system, wherein user has access to the logic, decision making and execution of the Algo system. This is also called Execution Algo. In aforesaid example, we discussed the logic, its outcome and execution of cash segment inter-exchange arbitrage. An Algo system based on this logic will be called White Box Algo.
On the other hand, a Black Box Algo is fully opaque. You only know the outcome. You don’t have access to the logic, rationale and decision-making process of Algo system.
What is SEBI’s proposal? SEBI has proposed to allow algo trading to investors through their brokers. The Algos will be back tested and approved by Exchanges. Brokers will be permitted to use such approved Algo. Each order placed through Algo trading API (Application Programming Interface) will be tagged with a unique identifier. How will Exchange identify that a trade has been placed manually or through Algo system? The circular says that the speed of order will determine the classification. All orders above a specified order per second threshold will be treated as Algo order. The Exchange system will take a note of this, and the data will be available for analysis. There are chances wherein orders placed by a dealer at fast speed may be classified by the Exchange as Algo order due to specified order per second threshold. SEBI draft circular emphasizes the speed of order and back testing of an Algo API for empanelment.
Where lies the problem? A retail investor or an ordinary broker can’t match the speed of Institutional giants. In case of White Box Algo, wherein program logic is accessible, a Counter Algo can easily be developed to eat away all the retailors. Reliance on back-end testing for evaluation of an Algo is illogical. Nobody can guarantee the continuation of past return. An Algo which made profits during last six months may generate negative return in the seventh month. Who will suffer? The retail investors. SEBI has asked exchanges to develop KILL SWITCHES to stop a faulty Algo. What is Kill Switch? It is an emergency system and last level of defence against any algorithmic malfunction. It is supposed to halt all trades emanating from a faulty Algo. Let me remind readers that SEBI has itself confessed on several occasions that monitoring of option contracts open interest on real time basis is difficult to monitor and therefore Algo APIs based on Option may prove a disaster. By the time, Exchanges gather data, analyze it and put up an approval note for using KILL SWITCH, everything will be washed away. Who will suffer? The retail investors. Who will gain? The Algo giants like Jane Street who earned more than 50000 crores from Indian Option market last year through their Algo system.
What is the remedy? Algo trading is a fancy word like Artificial Intelligence (AI). SEBI should make it mandatory for Algo traders to acquire a certificate from NISM or NCFM for Algo trading. Robust guidelines regarding Speed of internet, Soundness of Algo API, mechanism for real time monitoring and intervention of trades put through Algo and well-defined protocol for timely use of KILL SWITCH are some of the measures which may safeguard retail Algo traders.
Opening doors of Algo Trading for retail investors is a welcome move but safeguards are a must. Exposing retail traders to Algo trade without proper safety mechanism may prove catastrophic.
