The real world use case of technologies such as artificial intelligence ("AI"), machine learning ("ML"), blockchain and cloud computing has gradually transitioned from 'aspirational' and 'nice to have' to 'must have' and 'right here, right now'. The Indian financial services sector is in the forefront of integrating these technologies across their product chains to capitalize on the superior security, speed, convenience, and customer value, that the new technology induced experience provides.
The consequent disruption of traditional financial services using these technologies has resulted in mushrooming of new business models and redrawing of the financial services sector landscape. Unregulated, technology focused fintech entities have been enabled to enter regulated businesses. Similarly, traditional securities market intermediaries such as stockbroking, investment advisory services, research analysis services etc. are not only able to integrate new technologies into their primary business (which is regulated by financial sector regulators such as the Reserve Bank of India ("RBI") and the Securities and Exchange Board of India ("SEBI")), but also use their financial heft and technological prowess to foray into providing unregulated technology focused services to third parties.
End users have lapped up these technology heavy financial services and have made it imperative for financial services intermediaries to keep up with the Joneses. This is evidenced by the commanding market share held by technology-enabled stockbrokers1 and the exponential growth of assets under management for technology-enabled investment advisers or robo-advisers2. Such technology-enabled intermediaries typically tend to have multiple regulated businesses in the same group by building synergies based on common technology within the group.
This has led to interesting questions on the regulatory strategy to be adopted in this rapidly evolving financial services landscape. Under the extant regulatory framework, SEBI requires a principal officer and/or a compliance officer to be appointed by most categories of market intermediaries. But because of these new technologies, capital market intermediation business can be made 'human-free' to a great extent. While such 'human-free' technologies have their advantages, in a regulatory environment which is largely human-centric vis-à-vis accountability and compliance, it also has the potential to blur the line between unregulated technology services and regulated services. In this context, this article outlines the relevant regulatory landscape around the use of such disruptive technologies particularly in the securities market and points out challenges and regulatory ambiguities that stakeholders and investors may face in adoption of such technologies.
ALGORITHMIC TRADING IN SECURITIES MARKET
SEBI defines algorithmic trading or algo trading as 'any order that is generated using automated execution logic'3. In simpler words, algo trading entails the use of pre-programmed trading instructions that uses a computer to place an order for trading, thereby eliminating human intervention. Generally, the features of algorithmic trading include using a defined set of instructions in the form of algorithms to generate trading signals and placing orders, wherein an algorithm automatically monitors the stock prices live and initiates an order when given criteria are met4.
The entry of technology which enables such algo trading has re-defined the traditional stock-broking business. This is evidenced by the rapidly declining share of non-algorithmic trades executed on India's stock exchanges wherein around 75% (seventy five percent) of the total trades on the Bombay Stock Exchange and the National Stock Exchange are trades executed using an algorithm or a computer program5.
Back in 2012, SEBI had recognised that technological advancement, i.e., the use of algorithms for trading in securities, was bringing a vast array of challenges for effective regulation. Some of the major challenges were (i) system load – i.e., the number of active processes at a time, which needed to be managed; (ii) the order-level risk, like price risks or quantity risks; and (iii) identifying dysfunctional algos i.e., algos leading to loop or runaway situations.
To address such challenges, SEBI issued a circular ("Circular") which introduced guidelines which inter alia required stockbrokers to (a) obtain prior approval from the stock exchanges before offering the facility of algo trading; (b) perform risk checks related to price, quantity, order value and automated execution; and (c) submit an undertaking to the stock exchanges stating amongst other things that they have proper procedures, systems, and technical capability to carry out trading through the use of algorithms6. These guidelines have been reviewed by SEBI multiple times over the past decade7, wherein further governance and compliance measures have been introduced for stockbrokers. These measures include, among others, (a) getting trading algorithms certified by a Certified Information Systems Auditor (CISA)/ Diploma in Information System Audit (DISA) auditor; (b) performing risk assessments; and (c) ensuring that no references to the past or expected future return or performance of the algorithm are made in marketing.
While the technology involved in algo trading has mostly been of impact only to stockbrokers, the ability to analyse live market prices at large volumes and at a high velocity can prove invaluable to other securities market intermediaries such as investment advisors, portfolio managers and research analysts. The Circular on algo trading deals exclusively with stockbrokers, and accordingly, there currently is a void in regulation for the usage of such technologies by other securities market intermediaries. Further, while SEBI in 2015 issued guidelines to securities market intermediaries on principles to be adopted by them with regard to outsourced activities, there is currently no guidance on the technological services that can be outsourced to an unregulated entity for enabling algo trading, thereby further blurring the regulatory line.
3. Securities and Exchange Board of India, Circular Number SEBI/HO/CDMRD/ DMP/CIR/P/2016/97 titled 'Broad Guidelines for Algorithmic Trading for National Commodity Derivative Exchanges' dated September 27, 2016.
4. Securities and Exchange Board of India, Consultation Paper on 'Algorithmic Trading by Retail Investors' dated 09 December, 2021 available at https:// www.sebi.gov.in/reports-and-statistics/reports/dec-2021/consultation-paper-on-algorithmic-trading-by-retail-investors_54515.html
6. Securities and Exchange Board of India, Circular Number CIR/MRD/ DP/09/2012 titled 'Broad Guidelines on Algorithmic Trading' dated March 30, 2012. .
7. Securities and Exchange Board of India, 'Consultation Paper on Algorithmic Trading by Retail Investors', dated December 09, 2021; Securities and Exchange Board of India, Circular Number SEBI/HO/MIRSD/DOP/P/ CIR/2022/117 titled 'Performance/return claimed by unregulated platforms offering algorithmic strategies for trading' dated September 02, 2022;
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