Some market insiders are apprehensive that a directive issued by the Securities and Exchange Board of India (SEBI) on February 4, 2025, might be exploited by unethical algorithmic (algo) traders.

According to industry sources cited by Moneycontrol, the directive could lead to algo service providers or vendors developing strategies that prioritize generating higher trade volumes over delivering solid returns for investors.

When Moneycontrol sought SEBI’s response via email on March 17, the regulatory body clarified that while brokers have the authority to determine the compensation for algo providers, they must ensure transparency through adequate disclosures to clients and avoid conflicts of interest.

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SEBI’s Regulatory Framework for Algo Trading

The directive issued on February 4 introduced a structured framework to regulate algorithmic trading services for retail investors. Acknowledging the rising demand for algo services among retail traders, SEBI aimed to create a safer trading environment for them.

While the initiative was largely welcomed by industry players, including traders, brokers, and some algo service providers, concerns emerged over the compensation model for algo vendors employed by stock brokerages.

The Core Issue

Under the new guidelines, algo vendors must register their algorithms with stock exchanges through a broker. The broker serves as the principal, while the algo vendor acts as the agent. However, retail traders coding their own strategies for personal use or for immediate family members are exempt from this registration requirement, provided their trade execution remains below a specified frequency.

The directive specifies that vendors will receive compensation based on a portion of the brokerage firm’s earnings. “Algo providers and brokers may share the subscription fees and brokerage collected from the client,” the circular states.

Market insiders caution that this compensation model could be manipulated. Since vendors can earn more if brokers generate higher brokerage fees, there is a risk that some algo providers may design trading strategies that execute excessive trades—not necessarily to maximize investor returns but to increase brokerage commissions and their own earnings.

“There are already existing arrangements where algo vendors receive between 30-60 percent of the brokerage generated,” revealed an industry insider.

Moreover, the incentives are higher if an algo provider has a close associate registered as an Authorized Person (AP) under the broker. “If the vendor or a family member (registered as the broker’s AP) brings in clients, they could receive a brokerage share as high as 60 percent. If the broker acquires the clients instead, the commission might be around 30-40 percent,” the source explained.

SEBI’s Position

In response to Moneycontrol’s inquiry, SEBI stated that brokers have the flexibility to decide how they compensate algo providers. However, they must disclose all relevant details to clients to prevent conflicts of interest.

According to the circular, “There is no restriction on the broker regarding brokerage or subscription fee-sharing arrangements. They may opt for a fixed fee, a monthly fee, or any other mutually agreed-upon structure with algo providers. The disclosure requirement is designed to mitigate conflicts of interest. Therefore, brokers must fully disclose all charges to clients, ensuring transparency.”

SEBI also emphasized in its circular that “prominent and complete disclosures of all charges shall be made to the client. The broker must ensure that such arrangements do not create conflicts of interest.”

However, some industry experts believe these safeguards may not be sufficient. Many retail clients may lack the expertise to fully understand the disclosed information, making them vulnerable to potential exploitation. One source also pointed out that brokerage firms could claim ignorance if a trading strategy was intentionally designed to maximize commissions rather than investor returns.

On the issue of an AP registering as an algo provider, SEBI clarified that it has not encountered such cases. “An AP, by definition, acts as an agent of the broker and serves investors. We have not observed instances where an AP is also registered with stock exchanges as an algo provider,” the regulator stated.