[By Gagireddy Vyshnavi Reddy]
The author is a student of Tamil Nadu National Law University.
Part-1
With the advancement of technology, the incorporation of algorithm strategies into the trading of securities has emerged and has been growing at an exponential rate since then. The provision of algorithm strategies for the purpose of trading securities can be sought in two ways, where one of them is by the provision of such strategies by the stock brokers themselves, however, another way is through the third party algorithm strategy providers, where the stock brokers outsource the services of the third party algorithm strategy providers. SEBI in its Consultation Paper on Algorithm Trading by Retail Investors, 2021 has stated that the services provided by such third party algorithm strategy providers cannot be categorized as either investment advisor or a research analyst and thereby such third party service providers are not recognized. This article focuses on how there is mis-regulation of such third party algorithm strategy providers, and how their services cannot be interpreted as investment advisors but can be categorized as research analysts henceforth eliminating the unnecessary burden placed on the stock brokers in gaining permission for each and every algorithm strategy employed from the third party algorithm strategy provider by not recognizing the third party algorithm strategy providers under a regulatory framework.
INTRODUCTION
Algorithmic Trading has been used very widely in India from the past few years. According to report from the National Institute of Financial Management submitted to the Department of Economic Affairs indicates that over 50% of total orders at both the National Stock Exchange and Bombay Stock Exchange are algorithmic trades on the client side, while over 40% are trades on the prop side. Algorithmic Trading refers to an automated execution of logic that generates a buy or sell order of the securities in the securities market. It enables the investor in trading the securities when there is an appropriate market situation that enables the investor in gaining profits. This would not require the interference by the investor in analyzing and keeping a track on the market conditions in order to trade the securities.
The rise of algorithmic trading in India can be traced back to SEBI’s Circular on Introduction of Direct Market Facility in 2008 (2008 Guidelines) allowing institutional investors to use the direct market access (DMA) facility, which allowed brokers to offer their clients direct access to the exchange trading system without any manual intervention. Later, SEBI released the “The Broad Guidelines on Algorithmic Trading” (2012 Guidelines) and these 2012 Guidelines provide for seeking mandatory approval by the stock brokers from the stock exchanges for providing the service of algorithm trading to the investors. It also provides various other compliance for the stock brokers and the stock exchanges to be followed in order to enable the investors with the facility of algorithm trading by providing algorithm strategies. Further, SEBI has also released the Consultation Paper on Algorithmic Trading by Retail Investors (Consultation Paper) in 2021, wherein, it stated that there would be no recognition given by SEBI to the third-party algorithm strategy providers (ASPs) creating such algorithms and has instead placed multiple reporting requirements on the stock brokers in order to regulate such third party ASPs. It also mentioned in Consultation Paper, how it is unclear as to the categorization of the services provided by these third party ASPs as either investment adviser or research analyst and thereby concluded to not grant a recognition for such third party ASPs. This article deals with the above mentioned aspect of the Consultation Paper, how the third part of how the third party ASPs are mis-regulated by first establishing that the third party ASPs do not come under the current Investment Advisor Regulations and later establishing that such third party ASPs can be interpreted under the Research Analyst Regulations. It concludes with the suggestion that instead of placing extra burden on the stock brokers for obtaining permission for every algorithm employed from the third party ASPs by eliminating the third party ASPs from the regulatory framework, SEBI can regulate these third party ASPs as under the Research Analyst Regulations, 2014.
REGULATORY OVERSIGHT ON THIRD PARTY ALGORITHM TRADING STRATEGY PROVIDERS
An Algorithm Trading Strategy is a logic employed by the investor to execute orders in the securities market. These include using a defined set of logic and instructions in the form of algos to generate trading signals and placing orders as mentioned in the Para 2.1 of the Consultation Paper. These orders would emanate with minimal human interference by placing them as and when the required criteria of the investor is met. This is done by constant analysis and monitoring of the stock market and employing the provided logic to understand if an order can be placed for such investor.
These algorithm trading strategies are majorly of two types, the first generation algorithm trading strategies and the second generation algorithm trading strategies. First generation strategies are those which consists of human-defined, rules-based strategies that are transformed into computer code and then executed through sophisticated technological infrastructures that connect firms to markets. Whereas, the second generation strategies consists of the machine learning approach wherein machine learning system in itself creates the strategy basing on the objective function of the investor and creates trading rules which are automatically implemented into the market in the form of orders to buy or sell the securities of such investor. This blog deals with only the first generation algorithm trading strategies and does not concern about the second generation algorithm trading strategies.
The usage of the first generation algorithm trading strategy can be predominantly provided in two ways (Algorithm Strategies). While stock brokers offer algorithm strategies to the investors in-house, at the same time, the brokers can outsource the services of the third-party ASPs. These strategies would be thereafter offered to the investors by the stock brokers. In the second scenario, it is important to understand the regulatory framework of such third-party ASPs. As mentioned earlier, SEBI in its Consultation Paper has stated that it does not recognize the third party ASPs and instead places the burden of seeking approval of such algorithms on the stock brokers, wherein, the stock brokers are responsible for obtaining the necessary approvals for each and every algorithm strategy employed by them, including the strategies emanating from the third-party outsourcing of the algorithm strategies. The important take away is that the third-party algorithm strategy providers are completely excluded from the regulatory oversight.
The consultation paper states that there still needs to be a clarity as to the nature of the services provided by the third-party algorithm strategy providers. It also noted that the information available is not sufficient to ascertain whether such third-party algorithm strategy providers would be classified as investment advisors or research analysts and thereby be guided by the respective regulations. It has also provided an option for the brokers to provide the details of the services provided by such third-party algorithm providers, in order to ascertain the nature of there services. However, while the nature of the algorithm strategies cannot be categorized as investment advisors, it can be interpreted as research analysis. .
Third Party Algorithm Strategy Providers vis-a-vis Investment Advisors:
It is to be understood that the services provided by the third-party algorithm strategy providers clearly does not constitute as an investment advisor. Looking into the definition of investment advice, as provided in the Regulation 2(1)(l) of the SEBI Investment Advisor Regulations, 2013 (Investment Advisor Regulations) wherein an investment advice means advice relating to purchasing selling or dealing in securities and the same should be for the benefit of the client. Looking into the third-party first generation algorithm strategy providers, among which most of them are the off-the-shelf algorithm strategies, these contain the trading strategies already pre-loaded into the algorithm. This strategy is not tailored to result benefits to the client. It is unknown to the third party provider if such strategy would result in the benefit of the client or not, but instead is dependent on the investor in choosing the right strategy that is provided off the shelf. The strategies provided are mere logical and mathematical analysis in relation to the securities market and this is in no manner an investment advice given to a particular investor, rather are the tools the investor uses in order to gain profits.
As required by the Regulation 16 of the Investment Advisor Regulations, an investment advisor should conduct any risk assessment of the client and the capacity of absorbing loss by the client. The strategies provided by these third party ASPs do not encompass the requirements and the risk nature the investor wishes for, rather are mere calculations for helping the investor decide if and when an order is to be placed and such calculations are based on a general analysis of the market. Therefore, there is no risk assessment done and there is no analysis made by the service provider on the loss absorbing capacity of the client. Another important facet to be considered is the fact that such off the shelf strategies provided by these third party ASPs are available and accessible by everyone. Such strategies are not customized or designed in accordance with the needs of a single investor and are therefore not exclusive to any investor but for everyone trading an investing in the stock market. The proviso to the Regulation 2(1)(l) of the Investment Advisor Regulations state that the investment advice that is widely available to the public will not be considered as investment advice under such regulations. While these off the shelf strategies are accessible and provided to everyone and not just a single investor particularly, such services cannot be considered as an investment advice.
Looking into the customizable algorithm trading strategies, although these entail the aspect of “benefit of the client” and tailored strategies, these still cannot be categorized as investment advise for the reason that they are not concerned with any specific securities or investment product. Regulation 4(a) of the Investment Advisor Regulations provide exceptions from the Regulation to certain types of investment advice. An investment advice, if in the form of a general comment on the market trends and the economy would be exempted from the Investment Advisor Regulations. Additionally, an investment advice that is not directed towards a particular investment or a security of a company or an offer are also exempted from the Regulation. Looking into the aspect of customized algorithm strategies, wherein the strategy is devised in accordance to the risk and return factors of the investor, it is pertinent to understand that such strategies are still in the form of general comment on the market trends and the economy. Since these strategies are not devised considering a particular security or an offering of a company but are devised for the general application for the investor, such strategy would be of the nature of a general comment on the market trends but in accordance to the risk and return factors of the investor. The customization characteristic of these strategies do not diverge it from the nature of being a mere comment on the market trends and the emerging economies. Henceforth, even the customizable algorithm strategies would not come under preview of the Investment Advisor Regulations. Therefore, it can be said that the third party ASPs that are offered off the shelf and that can be customized, cannot be termed as investment advice as under the Investment Advisor Regulations.
Part-2
Having dealt with how the algorithm strategy providers do not come under the ambit of Investment Advisor Regulations, the article further goes on to deal with how the algorithm strategy providers can be regulated under the SEBI Research Analysts Regulations, 2014.
Third Party Algorithm Strategy Providers vis-a-vis Research Analysts:
While the Investment Advisor Regulations do not cover the third party ASPS, The SEBI Research Analysts Regulations, 2014 (Research Analysts Regulations) cover the third-party algorithm strategy providers in its ambit. The definition of “research analyst” as provided in the Regulation 2(1)(u) of the Research Analysts Regulations, includes offering an opinion concerning public offer or gives price target or makes buy/sell/hold recommendation and also includes the person who publishes or prepares a research report. Further, Regulation 2(1)(w) of these Regulations provides for the definition of a research report wherein it includes any written or electronic communication that includes research analysis or research recommendation or opinion on the securities or public offer, providing a basis for investment decisions. Looking into the nature of the off the shelf third party ASPs, these are the logical and mathematical trading approach embedded into a code in an algorithm and provided to the public at large. These trading approaches and strategies are formulated on the basis of information and research analysis done on the securities market and the behavior of the market.
For example, one of the most used algorithm strategy, the Arbitrage Strategy where it takes advantage of a dual listed security, wherein it executes an order as and when there is a high price difference and thereby buying the security at lower price and selling the security at higher price simultaneously. Another example can be the VWAP strategy wherein in case of bulk order to be executed, the strategy breaks the trade into smaller volumes and ensures the execution price is closest to the Volume Weighted Average Price (VWAP). It can be seen that in both of these strategies, the important aspect is that these strategies are of the nature of research analysis of the market and the securities, whereby such strategies are nothing but the recommendations and analysis of the securities embedded into a code in an algorithm. In addition to these well known strategies, the third party ASPs can also device new strategies, in accordance with the trends of the market. They would be latersold off the shelf to the stock brokers. In such a scenario, these strategies would also be in the nature of the research analysis or research recommendation of the securities. It can be therefore interpreted that the algorithm strategies provided off the shelf by the third party ASPs are of the nature of a research report and the person/group of persons publishing such research report in the form of a code embedded in an algorithm, is nothing but an electronic communication of such research report and thereby be categorized as research analyst under the Research Analyst Regulations.
The Consultation Paper states that the nature of the services provided by these third party ASPs cannot be interpreted as research analyst and thereby eliminated such providers from the regulatory recognition. In order to regulate such algorithm strategies, the burden is placed on the stock brokers to seek permission for every strategy employed from such third party ASPs. However, by the above interpretation, if a strategy is interpreted as a research report and the providers of such strategies as research analysts, the requirements and restrictions under the Research Analyst Regulations can be applied to the third party ASPs. The Research Analyst Regulations provide for a minimum qualification to procure and continue the registration as research analysts. Regulation 7(1) of the Research Analysts Regulations provides for a minimum qualification to get registered under these Regulations and Regulation 7(2) of these Regulations provides that such research analysts registered shall possess the NISM Certification at all times. Therefore, with these requirements in place among all the other restrictions and requirements of the Research Analyst Regulations, the algorithm strategies can be regulated by the timely reporting by the third party ASPs. Additionally, it would also ensure that these strategies are devised and prepared by the qualified professionals with the qualifications mentioned under the Research Analyst Regulations and would enable minimum standards in the trading logic and instructions.
SUGGESTIONS AND CONCLUSION:
Algorithm trading is one of the prominent and growing aspect of the Indian markets currently. It has been a considerable amount of time, since 2008, for the regulators to pick up with the pace of the algorithm trading in the market and make the regulations accordingly. However, due to mis regulation of the third party algorithm strategies and non regulation of the third party ASPs, there is unnecessary burden placed on the stock brokers and is allowing a leeway for the third party ASPs to formulate strategies without adhering to the requirements and qualifications provided under the Research Analyst Regulations. Its high time that the third party algorithm strategy providers should be regulated and be recognized as research analysts as under the Research Analyst Regulations. This would make sure that there is a minimal level of standards and quality check of the strategies provided to the public and would also be able to govern them by placing the burden on the ASPs rather than the stock brokers.The Consultation Paper expressly mentions that the third party ASPs cannot be governed under the Research Analyst Regulations and therefore would not regulated under any law. It would be a immense oversight by the SEBI if these third party ASPs are left unregulated. Moreover, when the services provided by such third party ASPs are of the nature of research analysis and come under the purview of Research Analysis Regulations, SEBI should make sure the eligibility and the reporting requirements are followed by these third party ASPs. A clarification from SEBI regarding the governance and regulation of third party ASPs under the Research Analyst Regulations is the need of the hour. However, the interpretation of the third party ASPs as research analyst can be done only with regard to the off the shelf algorithm strategies, while the customizable strategies still do fall neither under the Investment Advisor Regulations or the Research analyst Regulations. Either of these regulations should be expanded in a way to adopt to the intricacies and nature of the algorithm strategies. The Consultation Paper mentions that there is no enough data for identifying the nature of such strategies, but it is to be noted that this paper was released way back in 2021 and there has already been enough time to procure the alleged data that is mandatorily required to interpret the nature of the algorithm strategies. In conclusion, with regard to he most popular off the shelf algorithm strategies provided by the third party ASPs, the Consultation Paper has erred in stating that they cannot be categorized under the Research Analyst Regulations, while such third party ASPs providing off the shelf strategies can be categorized as research analysts. Its high time SEBI should explicitly convey that such providers should mandatorily adhere to the Research Analyst Guidelines in order to remove further confusions and mis regulation in this aspect.