Commerce for IAS – Decoding Algo Trading
Recently, The Securities and Exchange Board of India (SEBI) has decided to further tighten the regulations for algorithmic trading to minimise instances of misuse of such system.
What is algo or algorithmic trading?
Algorithm trading is a system of trading which facilitates transaction decision making in the financial markets using advanced mathematical tools. It is a trading system that utilizes advanced and complex mathematical models and formulas to make high-speed decisions and transactions in the financial markets. Algorithmic trading involves the use of fast computer programs and complex algorithms to create and determine trading strategies for optimal returns.
In developed markets like the US, more than 90 per cent of the trades (at much higher volumes) are done using algorithms. Also, there are not many restrictions on retail investors using algos to trade.
What makes algo trading to stand out in Indian Financial Markets?
In this type of a system, the need for a human trader’s intervention is minimized and thus the decision making is very quick. This enables the system to take advantage of any profit making opportunities arising in the market much before a human trader can even spot them.
Speedy trade execution, accuracy and reduced costs are factors that make algorithm trading popular among investors. It minimises “emotions” (while investing) and keeps investors on a preset plan.
On the flip side, Mechanical failures and software glitches are the biggest disadvantages of algo trading.
Algo Trading & India
Algo trading, was introduced in India in 2009 and has managed to catch the fancy of large traders since then. The appeal of these trades has grown over the years and these trades currently account for around 40 per cent of the exchange turnover.
However, the number of rules and regulation imposed by the market regulator, the Securities and Exchange Board of India, is a deterrent. The exchanges where the algo is to be used have to check the algo program and approve it before it is put to use. Getting the approval is cumbersome, keeping out many traders.
Retails investors in India are still miles away from algo trades. There are apprehensions that allowing small retail investors to trade using algorithms would be like giving a gun to someone who can’t shoot. Stringent approval processes have also restricted the spread of algorithm trading among retail investors.
Concerns over Algo trading
Sebi feels that algo trades run the risk of creating distortion in the capital market. Since market participants have been using hi-tech tools in algo trades, it may create a non-level playing field in the market.
In the recent times, participants have started using algo trading for their own benefit. Algo trades always have a large number of trades which may hamper the risk management of the stock exchanges and might impact capital market adversely.
Algo trading gathered more light after a whistleblower alleged that a stock exchange was giving unlawful access to some brokers.
Hence, the need is felt for more stringent regulations for algo trading.