On 12 February 2018, the FCA published a report on Algorithmic Trading Compliance in Wholesale Markets. At first sight, this looks like an early warning shot from the UK regulator with fresh ammunition from the recently implemented MiFID II (for more on requirements in this area, see our paper MiFID II: Considerations for Algorithmic and High-Frequency Trading Firms).
Whilst this is not an inaccurate interpretation, we believe the FCA’s report has wider application: to firms who have not deemed themselves algorithmic traders, but may in fact be subject to some requirements; and to understand how the FCA will look to enforce MiFID II’s new rulebook across the board. In other words, even if you do not class yourself as an algorithmic trading firm, don’t stop reading!
The FCA re-iterates its interpretation that MiFID II’s organisational requirements for algorithmic trading firms apply beyond the narrow Investment Firm definition. Thus, any manager of a collective investment undertaking pursuing an algorithmic trading strategy, either as a direct member of a regulated market, or participant of an MTF, is subject to these requirements, as well as AIFMs pursuing such strategies with respect to their managed account business. The FCA combines this with a fresh take on the definition of algorithmic trading (and its sub-set, high-frequency trading) – with the implied threat that it will look closely at whether firms have correctly categorised themselves.
What are the FCA's main concerns about algorithmic trading?
The opening section to the report, Key areas of focus, provides a helpful summary of the FCA’s order of priorities. These should come as no surprise:
- Defining algorithmic trading: firms should have robust methodologies for identifying algorithmic trading activity, and what would define a material change to this activity triggering appropriate testing and record keeping.
- Development and testing: firms should have consistent and well-understood processes to test new algorithms so that potential issues are identified prior to deployment.
- Risk controls: firms have a duty to maintain appropriate pre- and post-trade risk controls to protect the interests of clients and overall market integrity (including “kill switch” functionality).
- Governance and oversight: firms are expected to maintain a framework which provides effective challenge from senior management, risk and compliance.
- Market conduct: firms should consider their algorithmic trading activity in the context of Market Abuse Regulation obligations to maintain appropriate monitoring and surveillance systems.
Applying the rules: a selection of examples of good practice
- Make a detailed inventory of algorithms and systems employed across the business: how they work (summary in plain English), who has primary responsibility, and what risk controls apply to each.
- Development and testing process documented in standard format, including independent sign-off from key functions (CIO, COO, risk, compliance).
- Risk controls maintained at multiple levels: front office, risk, compliance and senior management.
- Compliance conducting a gap analysis of their ability to supervise algorithmic trading activity, and allocate new responsibilities if necessary.
- Provide relevant market abuse training for staff involved in development and surveillance.
What does this tell us about the FCA’s future approach to MiFID II?
The FCA warns that “We will continue to assess whether firms have taken sufficient steps to reduce risks arising from algorithmic trading”. Although not explicitly stated in the report, we believe firms should expect:
- Further thematic work on algorithmic trading firms (probably with a focus on high-frequency trading at some point); and
- Challenge from the FCA on whether regulated firms have correctly understood the application of the rules, regardless of whether they categorise themselves as algorithmic or non-algorithmic trading firms.
During a month when the European Commission warned of the possible consequences of a no-deal Brexit (from March 2019), the report also signals “business as usual” from the FCA. The UK regulator intends to proceed on the assumption that the new regime will apply to UK firms for many years to come. The FCA has already indicated that the new inducement/paying for research rules will be another area of thematic focus. Transaction reporting (for in-scope firms) will likely (in our opinion) follow closely behind.
How ACA Can Help
- Independent Reviews: Advice, guidance, gap analysis and training; and
- ACA's Decryptex®: ACA can apply its MAR-based algorithms to meet FCA requirements, including verifying that the quant system is executed accordingly.
Please contact Martin Lovick or your regular ACA consultant with any specific questions or concerns about this paper.