Why do algo trading need regulatory approvals ?

This will be an open discussion to reach some clarity whether any form of algorithmic trading needs prior approval from regulatory bodies like SEBI. Something we frequently hear like – you need an NCFM certificate and get your algo approved by exchange.

These rules have overhangs of early days of 2008 when algo trading first started, background was – limited number of institutions adopted, still today very little or no awareness exist among retail traders It seems these law do not address algo trading from retail traders. Perhaps govt dont like retail traders participation.

What exactly is Algo trading

It is very important that we revisit the definition of algo trading – that is, execution of trades based on predefined criteria and without any human intervention using computer programs. Now the tricky bit is this consists of two items: first signal generation and order automation. Both can be done with computer programs. But from a regulatory perspective it is the order execution more a point of concern, More on this later.

Algo trading not equals to HFT

The word algo trading is often confused with HFT, HFT altogether different-ball-game, whereas a raw algo trading can be as simple as process automation earlier done by manual analysis. Mostly retail algo trading would mean some kind of trend follower or AI pattern recognition system.

HFT on the other side are the tools of institutions, who rent co-location servers from NSE and trade in high frequency, why has NSE placed approval requirements for them is, to prevent any abuse of core system, they want to safeguard themselves from failing if large numbers of orders are sent making them system crawl. Therefore its good to have checks and balances before installing any software on their premise.

Now rephrase our original question – do HFT needs, approval for 1. signal generation and 2. order automation ? Answer is Yes for both, because Exchange needs to know how many signals/seconds it will generate, and how many orders will submitted.

What about retail trader

Again asking the same question for a retail trader with a trend following algorithm, and using a broker interface to submit orders, do I need approval for 1. Signal generation, 2. Order submission.

For signal generation our understanding is, approval not required, but a concern from regulatory body is that, retail traders who are less tech savvy can make a significant loss from any unattended algo combined with a false notion that algorithm can magically handle losses, therefore any algo based order from retail must be manually reviewed. This is a semi automation, where a popup window would ask you whether you want to submit this order.

Any algo based orders routed through retail brokers cannot cross a certain speed limit. Plus they have proper request checking before forwarding them to exchange. This way no malicious orders can be sent.

So institutions definitely need approval but what about retail traders need approval – quest is still on !