The FCA has published a report, clarifying its expectations of firms that develop or use algorithmic trading strategies.
On 12 February 2018, the FCA published a report on algorithmic trading compliance in wholesale markets. Although the report largely focuses on the practices of larger firms that develop algorithms themselves, it is relevant to all firms that develop and/or use algorithmic trading strategies.
When firms were implementing the MiFID II algorithmic trading obligations under RTS 6, many questions were raised as to the scope of the obligations and how far the regulators expected firms to go — particularly in relation to the role of compliance, the kill functionality, and the post-trade controls required for risk management. The FCA report, therefore, should provide the industry with much-needed clarity as to their obligations, even if some of the FCA’s observations may go a bit further in some areas than many firms would like.
The FCA has identified five key areas of focus, and outlined some useful examples of what it considers to be good and poor practice in relation to each of these areas. We highlight below our thoughts on some of the key examples. The FCA states that it will continue to assess whether firms have taken sufficient steps to reduce risks arising from algorithmic trading, and that this will continue to be a primary concern for the regulator. Therefore, firms should pay close attention to the FCA’s expectations.
Defining algorithmic trading
FCA expectation: Firms must establish an appropriate process to identify algorithmic trading, manage material changes, and maintain a comprehensive inventory of algorithmic trading across the business.
• Firms who conduct extensive reviews (consulting all aspects of the business) to consider at length how trading algorithms are used within the firm. These firms are able to develop appropriate definitions and ensure relevant activities across the whole business are captured. Many firms will struggle to say that they do this so comprehensively, or that they truly consider the use of algorithms across the whole business. Firms need to think carefully about activities in all areas of the business, not just areas in which algorithms are widely used.
• Firms who don’t have clearly defined inventories in place and are only able to provide generic highlevel descriptions for their algorithms, strategies and systems. Firms need to have detailed descriptions in place, particularly as these descriptions are something the FCA might wish to inspect as part of its focus on algorithmic trading. So, firms should assume the FCA can understand the magic in the detail of an algorithm.
Development and testing
FCA expectation: Firms must maintain robust, consistent and well understood development and testing processes that identify potential issues across trading algorithms before full deployment.
• Firms who have checkpoints throughout the development and testing process (for example, after initial due-diligence was completed, at several stages during testing and prior to full deployment) with a full review at the end of each stage. This includes:
– An independent committee to check all the relevant documentation, ensure all testing procedures have been completed satisfactorily and verify that the algorithm is consistent with the original specifications
– Active representatives on the committee from Risk, Compliance, Legal, Business, Technology, Finance and Operations
– A dedicated software development team to provide independent verification before moving to the next stage
This is only really relevant to, and feasible for, larger firms with extensive algorithmic trading activities.
• Firms who are unable to provide effective MI to senior management on areas such as conformance testing, operational arrangements, pre-trade risk parameters, training and surveillance procedures prior to deployment. This is important not only for the firm, but also for senior management to document that they have provided appropriate oversight and, if necessary, challenge.
FCA expectation: Firms must develop suitable and robust pre-trade and post-trade controls to monitor, identify and reduce potential trading risks across algorithmic trading activity.
• Firms who maintain detailed controls at multiple levels. For example, by client and/or trading strategy depending on the type of business undertaken, as well as on a firm wide basis. These control settings are reviewed on a regular basis to ensure they remain appropriate. The FCA clearly is expecting a structured and sophisticated approach to risk controls; basic controls or arrangements that have not been tailored to the firm’s activities will not be appropriate.
• Firms who do not formally log incidents/breaches and fail to provide MI reports to appropriate forums. This prevents valuable MI being presented for senior management to identify potential emerging issues and risks. Firms need to consider how they detect concerning patterns over time, as well as individual incidents.
Governance and oversight
FCA expectation: Firms must maintain an appropriate governance and oversight framework that demonstrates effective challenge from senior management, risk management and compliance.
• Firms where algorithmic trading is fully understood by senior management, who play a key role in providing challenge across the business. For example, where senior management are involved throughout the development and testing process and actively seek to understand the potential market conduct implications. This is particularly noteworthy as the FCA is not only expecting senior management to take full responsibility for overseeing algorithmic trading activities, but for actually understanding the trading taking place. Senior managers who consider it appropriate to “leave it to the experts” should take note.
• Compliance functions who are unable to demonstrate that compliance staff have sufficient technical knowledge to oversee and monitor algorithmic trading activity effectively. Firms need to ensure that relevant staff receive appropriate training and have the right skills. Firms should also ensure that compliance staff understand not only algorithmic trading activity in general, but also the particular activities of the firm.
FCA expectation: Firms must consider the potential impact of their algorithmic trading on market integrity, monitor for potential conduct issues and reduce market abuse risks.
• Firms who consider how they can tailor their monitoring and surveillance systems to specific risks within their algorithmic trading activity and also ensure suitable market abuse training is conducted for all relevant members of staff. As demonstrated by a recent market abuse systems and controls enforcement case, the FCA expects firms to have tailored systems in place, reflective of the specific risks faced by the firm.
• Firms who maintain basic market abuse alerts such as insider dealing or layering and spoofing but do not consider other types of market manipulation which can be associated with algorithmic trading. For example, momentum ignition, quote stuffing and reference price gaming. Given the potential heightened risk of abuse, firms need to consider carefully the sorts of abusive behaviours that might occur, and keep abreast of any trends or developments.