The Senior Supervisors Group—an organization of senior representatives of financial entity supervisory authorities from 10 countries and the European Union—published a report with its observations of the material risks of algorithmic trading and how financial firms can mitigate such risks, as well as questions both firms and regulators should be asking to better reduce such risks going forward. According to the report, the key risks of algorithmic trading are that small risks can be exacerbated throughout markets causing sizable impacts, including large losses; algorithmic traders may have significant intraday risk “without transparency or robust controls;” and internal controls may be lagging behind increasing speeds and market complexity. The report suggests that risks can be mitigated by implementing a “defense-in-depth” strategy. This strategy would require redundant and diverse controls at multiple points including at an algorithm’s launch or change, during trades’ lifecycles, and in response to incidents. The report also argues for implementation of effective governance; testing at all phases of an algorithm’s lifecycle; and meaningful involvement of control functions. Among other questions the report suggests firms and supervisors should be asking are what type of risk reports are generated, especially intraday, and who monitors them (e.g., an independent risk management function); are control functions aware of controls on the trading desks and do they consider them satisfactory; and are the firm’s “incident response processes up-to-date, effective and communicated to senior management?”
Compliance Weeds: Not only can breakdowns in a firm’s automated trading system result in exchange fines (click here to access the article, “CME Group and ICE Futures U.S. Each Fine a Trader for Automated Trading System Malfunction” in the March 29, 2015 edition of Bridging the Week), but such breakdowns can result in a catastrophic result for the company with costs incurred by third parties (click here to access the article, “Korean Broker Default Raises Specter of Algorithmic Trades Gone Bad and Broker Liability for Fellow Brokers at Clearing Houses,” in the February 24, 2014 edition of Bridging the Week.) Recently, FIA published a comprehensive guide of best practices in connection with the development and implementation of automated trading systems. It’s well worth reviewing (click here to access).