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Together the documents represent further scrutiny of and more detailed expectations from the UK regulators on the use of algorithms by capital markets participants. The two regulators will continue to collaborate on the subject to ensure coordinated approaches going forward. The regulators stress the need for a comprehensive inventory of algorithmic trading systems as the foundation for an effective control structure, but also note the challenges of producing one, especially in larger firms.
Unsurprisingly the regulators identify the need for independent and informed challenge by the Board, the Risk Committee, Risk, Compliance and Internal Audit and other control functions at every stage of the algorithm lifecycle — from design, through testing to deployment and monitoring.
Following a detailed assessment of the development and implementation procedures used by firms for algorithmic trading ahead of implementation of MiFID II, the FCA identified five key areas of focus and set out a number of examples of good and poor practices in the each of the areas.
Defining algorithmic trading , with the objective to ensure that firms establish an appropriate process to identify algorithmic trading, manage material changes and maintain a comprehensive inventory of algorithmic trading across the business.
The FCA acknowledges that this identification process can be a challenge, especially for larger firms, but regards it as a prerequisite for robust governance and controls. The FCA can require firms to provide a description of their algorithmic trading strategies within 14 days. Good practice includes conducting extensive reviews of all aspects of the business to consider how trading algorithms are used within the firm. Firms also need to maintain a comprehensive inventory of algorithmic trading strategies and systems across the firm, which can provide MI for senior management.
Development and testing , with the objective to ensure firms maintain robust, consistent and well understood development and testing processes which identify potential issues across trading algorithms prior to full deployment. Before sign-off, firms need to complete a comprehensive review and approval process, and all stakeholders need to confirm that their assigned tasks are completed, verified and documented.
Firms should aim to have an independent committee to review the documentation and completion of testing procedures, and to verify that the algorithm is consistent with the original specifications. The FCA emphasises the need for challenge and for separation between development and validation teams — validators need to be empowered with the appropriate level of influence. Firms also need to establish a procedure to ensure any new or updated algorithms are deployed in practice in an appropriate and controlled manner, and the FCA notes the advantages of phased deployment into the production environment from a control perspective.
Throughout the development and testing process, firms should ensure they have adequate documentation and a comprehensive audit trail. Risk controls , with the objective to ensure firms develop suitable and robust pre-trade and post-trade controls to monitor, identify and reduce potential trading risks across algorithmic trading activity. In terms of post-trade control and monitoring, firms should also conduct control monitoring, for example through automated control thresholds to generate alerts.
Firms should also have committees comprising of representatives from areas such as trading, client coverage, compliance, risk and credit teams to review their controls, including parameter settings, amendments to controls and any limit breaches. Governance and oversight , with the objective to ensure firms maintain an appropriate governance and oversight framework which demonstrates effective challenge from senior management, risk management and compliance on algorithmic trading activities.
Moreover, senior management should be prepared to evidence an effective governance and risk framework for algorithmic trading activities by receiving suitable MI and having clearly understood escalation procedures.
Good practice includes where senior management participates throughout the testing and development process and understands potential market conduct consequences.
The risk and compliance functions should be involved at each stage of the development, testing and implementation process for algorithmic trading. The FCA particularly noted that risk and compliance staff should aim to have the required knowledge and skills including understanding the relevant technology risks to provide sufficient challenge to the development of algorithms.
Market conduct , with the objective to ensure firms appropriately consider the potential impact of their algorithmic trading on market integrity, monitor for potential conduct issues and reduce market abuse risks.
Firms also need to integrate market conduct considerations into their algorithm development processes. In considering the potential consequences for market integrity, firms should incorporate market conduct considerations into their testing process — a good practice would be to develop or use third-party dynamic testing environments that could assess how their trading strategies would perform in a period of market disruption and whether their strategies might worsen such a disruption.
The FCA also highlighted that firms using machine learnin g and artificial intelligence should consider how they can examine heightened risks to market conduct within their testing processes. Firms also need to comply with the relevant requirements under the Senior Managers Regime. The testing should involve all relevant functions and be carried out at a frequency and to a standard commensurate with the risks that the firm could be exposed to should algorithms or risk controls not to operate as intended.
The paper also sets out that any variation without any mention of a materiality threshold of an algorithm should be classified as a new algorithm and therefore subject to separate testing and approval. Testing should be undertaken by a competent team not involved in the deployment of the code.
Firms should consider revisiting the work they have undertaken in relation to MiFID II process implementation to ensure that the specific headings set out by the PRA are included. Manmeet Rana has more than 12 years of capital markets focussed regulatory consulting experience. Manmeet has supported more than 15 firms with MiFID II projects, providing technical advice on the implementation of rules, establishing governance frameworks and assessing programme effectiveness.
Simon has also worked with firms to define their programme structure, conduct gap analysis work and assist with the design and implementation of solutions across investor protection and market structure topics. She joined Deloitte in after graduating from the University of Cambridge, where she focused on International Development.
She has previous experience working in enterprise risk services and at a non-governmental organisation. The letters and numbers you entered did not match the image. As a final step before posting your comment, enter the letters and numbers you see in the image below. This prevents automated programs from posting comments.
Having trouble reading this image? Comments are moderated, and will not appear until the author has approved them. You are currently signed in as nobody. Name and email address are required. Email address will not be displayed with the comment. Areas of focus 1. The proposal is structured around five sections: While firms should have implemented a robust governance framework as part of MiFID II, they may not have assigned ownership for an inventory of algorithms, risk controls and processes for reviewing incidents where an algorithm or risk control has not performed as expected.
The PRA also expects firms to maintain a dedicated policy around algorithmic trading. Algorithm approval process by the firm: Prior to granting approval, each algorithm should have assigned owners and have completed testing successfully. The testing should include all relevant parties i. Risk Management and Other Systems and Controls function: The PRA would expect these functions to have the authority and expertise to challenge Front Office and to impose whatever additional risk controls are necessary for effective risk management.
Those responsible for operations and settlements also need to ensure that the system capacity aligns with post-trade processing capacity. The internal audit function should ensure that reviews of algorithmic trading activities are covered in its audit plans. Manmeet Rana — Director, Risk Advisory Manmeet Rana has more than 12 years of capital markets focussed regulatory consulting experience. Comments Verify your Comment Previewing your Comment.
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