Algorithm Trading – UPSC GS3

Algorithmic trading in financial markets refers to transaction orders generated by using advanced mathematical models that involves automated execution of trade.

It uses mathematical models and software codes to make transaction decisions on exchanges and execute them at high speed.

This technology-driven trading enables traders to take advantage of any profit making opportunities arising in the market much before a human trader can even spot them.

By the National Stock Exchange’s estimate, about 14% of the trading volume (and around 45 per cent of the trading value) is algo-driven.

Algos can place the user at greater risk. This is partly due to the lack of human intervention, and partly because they can be programmed to make simultaneous trades of different markets. It could spiral into a huge market-wide risk owing to lack of circuit filters.

The famous “Black Monday” crash of Wall Street on October 19, 1987, occurred because algos sold heavily without human intervention.

Regulator believes these modes of trading are risky and there is little understanding of how they function.

It can be misused for systematic market manipulation as well as to lure the retail investors by guaranteeing them higher returns

Potential loss from a failed algo strategy may be huge.

SEBI has proposed to treat all orders based on the Application Programming Interface (API) as algo-driven. Further, such orders should be tagged with an ID unique to the brokerage.

Brokers should perform a sequence of stringent checks on any API-based trades to ascertain if these are algos.

It has also stated 3rd-party algo providers could be treated as investment advisors and that two-factor authentication (which implies human intervention) be put in place.

It would impact retail traders and brokerages in terms of the cost of compliance.

It would retard the use of API-based technology, which smoothens trading processes for all investors.

SEBI already has many robust checks in place to ensure adequate margins are collected. It has circuit filters to halt trading if there is an extreme price move.

Major retail brokerages estimate around one in 2,000 clients uses algos. This can be tackled by adequate margining.

Imposing high costs of compliance under the assumption that every API user is an algo trader would punish every investor.

What is algorithmic trading? How does increasing adoption of algorithmic trading affect the stock markets? (200 Words)