Because they have become too big and pervasive and the time to regulate is long gone, points out Debashis Basu.
The market watchdog, the Securities and Exchange Board of India (Sebi), has told stockbrokers who provide algorithmic trading (algo trading) not to allow algo sellers to promise high returns on their trading platforms.
Algos meant for retail investors, or retail algos as they are called, have been publicising extraordinary returns for a long time.
It is good that Sebi is attempting to stop such mis-selling.
However, is the promise of extraordinary returns the only problem with retail algos? In my view, the problem is much bigger and very basic.
If you read Sebi regulations on investment advice, retail algos are illegal products.
Algos are preset buy/sell rule-based decisions coded into software programmes, based on various price patterns.
These programmes, when deployed through brokers, can execute trades automatically.
Algo trading has been allowed in India for more than a decade but only for institutional investors.
As India went into a lockdown in 2020 and work from home allowed trading from home as well, millions of new retail investors jumped into trading. There has been explosive growth in algorithmic trading.
Brokers are the bridge that connects investors with algo makers and are hugely supportive of the trend.
They have a ready customer base of investors that algo makers tap.
Algo trading generates massive volumes because the number of trades is not limited by the trader having to execute them one by one on a terminal.
The system can fire hundreds or thousands of trades per hour, leading to higher brokerage income.
At the same time, customers get the convenience of connecting with algos through existing broker accounts.
Indeed, brokers are the gateway to the stock markets; you cannot buy and sell shares without going through them.
Driven by this obvious meeting of interests, brokers offer third-party algo strategies to their clients.
Sebi regulates brokers, not algo writers, and hence it has chosen to put the onus on brokers to eliminate misleading claims.
All this is fine but the growth of retail algo raises many uncomfortable questions.
Algo as illegal investment advice and PMS
According to Sebi Investment Advisers Regulations, 2013, investment advice means 'advice relating to investing in, purchasing, selling or otherwise dealing in securities or investment products, and advice on investment portfolio containing securities or investment products, whether written, oral or through any other means of communication for the benefit of the client and shall include financial planning'.
Aren't retail algos offering advice on buying and selling stocks, which are investment products? A cursory look at the algo creators will show that the very purpose of algos is to offer buy/sell recommendations embedded in their programmes, often marketed by making wild claims.
But are they registered investment advisers (RIAs)? There are hardly any pure algo writers who are RIAs because the registration brings with it enormous bureaucratic compliances of risk profiling, recording the suitability and rationale of every investment advice and storing it for five years.
RIAs also have to sign long agreements with clients, offer various disclosures, and get yearly audits done.
It is almost impossible for anyone to follow Sebi rules, as applicable to RIAs, in a rapid-fire environment of programmed trading (Sebi's rules do not distinguish between trading and investment in accordance with its own definition of 'advice').
A plain reading of the rules shows retail algos are illegally offering investment advice.
It doesn't stop there. Algo marketplaces like Tradetron even violate the Portfolio Management Services regulation.
Tradetron promises its users: 'Realise your dream of being a PMS provider.' How? Tradetron will ensure its strategies 'will get executed across all brokerage accounts of your subscribers at one go. Regardless of whether there are 3 or 3000 -- in different quantities across different brokers'.
Despite such glaring violations all Sebi has so far done is to ask brokers to ensure that algo makers don't claim extraordinary returns.
Yet, Sebi does not hesitate to harshly penalise fully regulated and compliant entities for small mistakes.
Why is Sebi hesitant to ban retail algos despite obvious illegalities? Because they have become too big and pervasive and the time to regulate is long gone.
So what is the way out? We need a new paradigm of regulating advice.
The market has exposed the limitations of Sebi's antiquated and stifling RIA regulations and it is an opportunity to align rules with the reality of what investors want.
Regulations ought to be built around products that customers want and use.
Instead, Sebi regulations are built around academic theories about financial planning, which nobody wants. In reality customers want buy/sell recommendations -- the main activity in the investment business.
This is what every intermediary and unregulated entity provide, without bothering about the impossibly complex and restrictive regulations.
Through two new apps -- Rigi and Cosmofeed -- unregulated people are minting money, offering advice on options, futures, and stocks, which Sebi is perhaps unaware of.
Funnily, the course material issued by the National Securities Market Institute says that mutual fund distributors, sharebrokers, and insurance agents, who earlier acted as investment advisers, 'can no longer claim the title'.
In reality, all these intermediaries provide buy/sell advice and algo writers and app-based 'advisors' have joined their bandwagon.
The writing on the wall is clear. Sebi would do well to restrict advisory regulations to those offering financial planning and focus on creating a new simple framework for everyone offering buy/sell advice -- advisors, research analysts, algo writers, app-based tipsters, stockbrokers, and distributors.
Otherwise, the continuous 'illegal' supply of buy-sell advice by regulated and unregulated market players rising up to meet the demand of the market will make a farce of Sebi's archaic advisory regulations.
Debashis Basu is the editor of moneylife.in and you can read Mr Basu's earlier columns here.
Feature Presentation: Rajesh Alva/Rediff.com