ESMA has published detailed guidelines covering systems and controls in an automated trading environment. The guidelines are in response to issues such as the unexplained US “flash crash” in 2010 and a case brought on “Quantitative Investment Model” coding errors settled in 2011.
What are ESMA Guidelines?
These are the first Guidelines made under Article 16(3) of their new powers. ESMA will not be supervising the implementation of the guidelines. The FSA published the Guidelines on its website under the “Miscellaneous” section on 3 April 2012.
The Guidelines will therefore be considered as best practice by FSA supervisors during thematic reviews or risk assessments and authorised firms will be assessed for conformity with them.
What is the deadline?
ESMA indicated in publishing the guidelines that market participants should be in compliance with their contents by 1 May 2012.
Will I be covered by them?
These guidelines have implications for:
- asset managers that undertake systematic trading or have developed electronic order distribution systems
- the providers and users of direct market access (“DMA”) or sponsored access (“SA”)
- regulated markets/trading platforms
The eight guidelines apply to all instruments and are to be applied in accordance with the nature, scale and complexity of the firm.
Asset managers will be impacted by the guidelines in relation to the trading algorithms they deploy and any electronic order routing systems they develop, as well as any modifications they make to the DMA tools they utilise.
There are requirements in relation to the governance around these electronic systems – for example over the development and testing, monitoring and reviewing of trading algorithms. Compliance and risk management considerations must be included as part of the development stage prior to going live.
Asset managers need to consider the rules of the exchanges and trading platforms where they are ultimately executing, as well as the applicable regulatory requirements in the development of their electronic systems. The guidelines recommend that the platforms require certain standards in relation to the knowledge of those individuals within the asset managers that are responsible for order entry.
Trading systems must be monitored in real time and action taken where any issues are discovered. In February 2011, an asset manager using a ‘Quantitative investment model’ agreed to pay $217m to harmed clients and a $25m penalty after it came to light that they had identified a coding error but concealed its existence for a prolonged period, both internally and to clients, causing them significant losses.
A key requirement in the guidelines is for the compliance, monitoring and risk personnel to have sufficient access to the electronic trading systems and their activities, and more importantly to have the right skills in order to understand the firm’s trading flow. Control personnel are not expected to be able to interpret or alter the code of the electronic trading systems but they are required to be able to understand what they have been developed for and to assess this expectation against what they see in reality.
The guidelines in particular require asset managers to have strict controls around their electronic trading systems to prevent market abuse.
Brokers that provide DMA or SA are also covered extensively in the guidelines. Detailed governance requirements are placed upon these entities in terms of the capacity and resilience that their systems must demonstrate and in relation to the business continuity arrangements that must be in place.
It will remain the responsibility or the DMA/SA provider to ensure that any trading that they facilitate or allow through their market access is in line with the applicable rules and regulations. They will be required to conduct sufficient due diligence on those clients to whom they provide access and to have appropriate pre-trade controls in place.
Brokers must be able to block or cancel orders that do not meet certain parameters – for example, size or price. They must also be able to block orders in specific instruments if they are aware that the client to which they are providing access does not have permission to trade that particular instrument. The brokers too are required to have skilled staff that monitor the trading activity in real time or as close to it as possible and to alert the regulators to any suspicious transactions. Ultimately they must be able to halt a trade if they suspect it to be market abuse.
Regulated markets and MTFs
Regulated markets and MTFs are required to have sufficiently up to date and technically advanced systems to be able to cope with the business which takes place through them and be suitably robust to ensure continuity of service. There are similar governance requirements placed upon these entities as there are to those in the buy and sell sides above – they are required to have detailed governance frameworks with clear lines of accountability and detailed procedures for development through to implementation.
Trading platforms will be required to undertake due diligence on their members or participants, including any non-regulated entities, to ensure they have sufficient infrastructure and controls in place to meet the regulatory and platform rules.
A key focus of the guidelines is market abuse, and the platforms are required to have sufficient tools to allow them to monitor the activities of their participants (and the end users if applicable) for suspicious or illegal activity. The guidelines specifically refer to trading platforms having the ability to detect “Ping Orders”, “Quote Stuffing”, “Momentum Ignition” and “Spoofing”. In particular, the focus is on having staff with sufficient skills to be able to monitor trade flow and detect any abuses.
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