Firms and Senior Managers should expect enforcement activity to follow if they fail to meet expectations.
Algorithms underpin an increasing proportion of market trading activity, either in terms of execution or investment decisions, and are the subject of increasing regulatory scrutiny:
- the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) have both released guidance on firms’ use of algorithms in the first half of 2018, and
- the PRA’s June 2018 Supervisory Statement has emphasised the responsibility of Senior Management for algorithmic trading and the need for robust governance arrangements to be in place.
Algorithmic trading risks
The focus of regulatory enforcement action and litigation following the financial crisis has been on misconduct by firms, carried out by their employees. The subsequent transition of functions from human employees to computer algorithms has reduced such risks. However, a range of new algorithm-related risks have emerged that have the potential to give rise to regulatory enforcement action or litigation. These include:
- the creation of widespread losses or unmanaged risk positions
- the use of algorithms in connection with abusive trading strategies, and
- algorithms failing to withstand, or in some cases magnifying, low-frequency “shock” events in financial markets, such as surges in volatility.
Increased regulatory focus
- In February 2018 the FCA published Algorithmic Trading Compliance in Wholesale Markets which provided guidance on key areas of focus for algorithmic trading compliance in wholesale markets.
- This was followed in June 2018 by the PRA’s Supervisory Statement SS5/18 Algorithmic trading, which sets out the PRA’s expectations for firms’ risk management and governance of algorithmic trading.
- Both regulators addressed a number of common areas, including:
- identification and inventory of algorithms
- development and testing
- approvals, and
- risk controls
Senior Management Responsibility and Governance
There is however a clear emphasis in the PRA’s June Supervisory Statement on Senior Management Responsibility and Governance. The PRA’s stated expectations are that:
- “The management body should identify the relevant Senior Management Function(s) (SMF(s)) with responsibility for algorithmic trading and ensure that this is included in the SMF’s Statement of Responsibility.”
- “[T]he firm’s management body [should have and maintain] an understanding of the firm’s algorithmic trading and the risk controls viewed as most important to mitigate and contain the risks from algorithmic trading.”
- The governance framework defines lines of responsibility for matters including:
- the algorithmic trading policy and adherence to it
- reviewing and approving algorithms
- ensuring the inventories of algorithms and risk controls are accurate, and
- setting out and overseeing a process that reviews algorithmic trading incidents.
This theme is echoed in the FCA’s Algorithmic Trading Compliance in Wholesale Markets, which draws attention to the MiFID II requirements for:
- clear lines of accountability for algorithms
- effective management information and escalation of issues, and
- sign off by Senior Management of the firm’s annual self-assessment and validation of its algorithmic trading activity.
The FCA also emphasises the need for Senior Management to be able to articulate the standards set for development, testing and on-going monitoring of their algorithmic trading strategies and ensuring those standards are appropriate. The FCA, like the PRA, therefore expects a high degree of understanding and involvement in the firm’s use of algorithms at the Senior Management level.
What should firms be doing?
The PRA and FCA’s clear but challenging expectations emphasise the role of Senior Management and Governance. Firms should now be devoting time and resources to ensuring that any risks presented by their use algorithms are appropriately managed and controlled. Further guidance on how to comply with the Senior Managers and Certification Regime can be found using the SMCR Extension Toolkit.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.