Tue, Nov 13, 2018
Written by Florian Nitschke, Vice President, Compliance and Regulatory Consulting
The use of algorithms for routing and executing trades has been in the spotlight for some time, even more so since the infamous May 2010 flash crash in the U.S. Regulators are concerned about the potential impact of malfunctioning algorithms on the orderly functioning of markets and related knock-on consequences for financial stability. There are also concerns that algorithms can be used to manipulate markets and prices.
On 3 January 2018, EU regulators began enforcing stringent requirements for firms using algorithmic trading strategies and trading systems under the Markets in Financial Instruments Directive (MiFID II), which are detailed in Regulatory Technical Standard 6 (RTS 6). Crucially, firms are required to carry out an annual self-assessment and validation of their algorithmic trading activity against the regulatory requirements. Further, the results of these assessments can be requested by regulators at short notice.
A month later, the FCA and PRA each made clear their focus on the topic by publishing papers setting out their respective expectations: the FCA’s Algorithmic Trading Compliance in Wholesale Markets report, and the PRA’s Algorithmic Trading Consultation Paper 5/18, which has since resulted in a Supervisory Statement in June 2018.
UK regulators are now following up with firms that would be well placed to review their arrangements to ensure compliance with the increased regulatory expectations.
Given the level of regulatory attention on the topic, it is crucial to get these assessments right. In this article, we outline a summary of the key regulatory requirements, challenges and practical guidance for firms to consider for their self-assessment and effective operation of algorithmic trading environments.
The FCA’s paper helpfully structures the RTS 6 requirements into five chapters and provides the FCA’s own views on what it considers good and bad practice. The PRA’s paper covers largely the same areas but focuses on the accountability, governance and oversight arrangements that firms must have in place. Following are the key requirements set out in these documents and some of the challenges firms have faced in meeting them.
Firms must keep a detailed inventory of algorithms once they are identified. This record should describe the different algorithm types and functionality, their owners, the sign-off obtained and the risk controls put in place. In practice, the same algorithm may have different risk controls depending on its usage. A firm’s inventory might therefore be quite detailed and extensive.
The FCA therefore expects this pre-launch framework to involve:
Regulators also expect firms to consider market abuse risks in the algorithm design and development process. This should include how an algorithm could impact the wider market even where the automated activity itself would not fall foul of MAR.
We see firms facing some consistent challenges with their algorithmic trading environment:
Given the FCA’s guidance that it would expect a firm to have a view on all its algorithms, a practical approach is to create a complete inventory and design controls proportionate to the risks each algorithm poses to market integrity. This also has the advantage of avoiding long discussions about whether an algorithm is caught or not and allows staff to focus on the controls framework.
As a result, firms must review the processes in place at their third-party providers and should consider whether they need to supplement these with their own procedures. In practice, a firm may require that third parties provide an overview of their design and development work for each algorithm, with the firm then carrying out additional work to consider whether all risks have been sufficiently covered and mitigated. Where this is not the case, the firm should not use the algorithm unless it can make changes or customize the code.
The latter issue was raised by industry to the PRA in responses to its February consultation paper. The PRA maintained its view that at a minimum, a firm-wide oversight framework should be established whilst allowing for specific departmental or regional processes.
It is no small feat to develop and implement a single framework across business units with unified standards and reporting to senior management and the board. Firms would be prudent to allocate sufficient time, resources and planning to meet this expectation.
In practice, such independent reviews can result in additional burden and resource requirements. Firms must consider how best to ensure the independence of these testing teams whilst also managing their operation’s overall efficiency. Some firms might use 1st line teams from other business units, which might burden them with additional work and create a strain on their resources. Others might task their Risk or Compliance function to carry out testing, but this may require additional training and skills.
The PRA has made clear that they will use supervisory tools to work with firms on achieving compliance with the regulatory standards and expectations. As part of their business plan, the FCA have also stated algorithmic trading controls as one of the areas where they will carry out additional work. We are aware that the regulators have started to ask questions about algorithms as part of wider regulatory visits and reviews.
The self-assessments which firms will have to complete under MiFID II will serve as a first port of call for regulators. Therefore, such a review should be comprehensive and well documented. Substandard work will be sure to attract further regulatory questions.
If you would like additional information on this topic, please contact our expert team. At Duff & Phelps, our specialized, multi-disciplined Markets team has assisted investment firms and trading venues to address their algorithmic trading challenges and create fit-for-purpose arrangements that are in line with relevant regulatory expectations and industry practice.
Our team consists of experienced professionals including former heads and members of the FCA’s Markets division, stock exchanges and firms’ surveillance teams who have led and advised on markets regulatory policy such as MAR, enforcement investigations, framework reviews and remediation programs.
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