Shearman & Sterling LLP | Financial Regulatory Developments Focus | UK Regulators Highlight Expectations and Consult on Algorithmic Trading Supervision
Financial Regulatory Developments Focus
  • UK Regulators Highlight Expectations and Consult on Algorithmic Trading Supervision
    The UK Financial Conduct Authority and Prudential Regulation Authority have published co-ordinated papers on their expectations around firms' use of algorithmic trading strategies in wholesale markets. Firms have had to comply, since January 3, 2018, with new requirements introduced by the revised Markets in Financial Instruments Directive and related Regulatory Technical Standards. The FCA's paper sets out the applicable regulatory requirements and provides examples of good and poor practice for firms regulated by the FCA. Firms that are dual-regulated by the FCA and the PRA should also review the PRA paper, which takes the form of a formal consultation on a proposed Supervisory Statement, covering the PRA's expectations regarding firms' governance and risk management. The PRA consultation runs until May 7, 2018.

    Both the FCA and the PRA recognize that algorithmic trading can bring improved liquidity, contribute to falling transaction costs and, in regular market conditions, does not appear to harm market efficiency. Algorithmic trading can also, however, give rise to issues such as periodic illiquidity, market manipulation and potential threats to market stability due to errant algorithms or excessive message traffic.

    MiFID II has (along with related RTS) introduced new requirements that aim to mitigate and ensure the management of the risks that a trading algorithm might function in a way that could disrupt the market, or be deployed in a way that gains an unfair advantage over other market participants. Additional requirements are imposed where a high frequency strategy is employed and specific requirements apply to market makers using algorithmic techniques. These MiFID II requirements have been implemented by the FCA in the Market Conduct sourcebook of its Handbook and by the PRA in the Algorithmic Trading Part of its Rulebook. The MiFID II requirements apply to MiFID investment firms and also to some non-MiFID investment firms, such as collective investment firms engaging in algorithmic trading.

    The FCA's paper, "Algorithmic Trading Compliance in Wholesale Markets", follows firm-specific and cross-firm work undertaken by the FCA to assess in detail how firms have been developing, testing and deploying algorithmic trading strategies. It sets out examples of good and poor practices the FCA identified during the reviews it conducted ahead of MiFID II implementation. The FCA paper highlights the need for firms to make further improvements in a number of areas and summarizes five key areas of focus: (i) defining algorithmic trading; (ii) development and testing of algorithms; (iii) risk controls; (iv) governance and oversight; and (v) market conduct.

    The PRA's consultation paper highlights that risk controls linked to a firm's risk appetite are crucial to manage the risks stemming from algorithmic trading. The proposed Supervisory Statement sets out the PRA's supervisory expectations on firms in five sections: (i) governance; (ii) algorithmic approval process (by the firm); (iii) testing and deployment; (iv) inventories and documentation; and (v) risk management and other systems and controls functions. The proposed Supervisory Statement will apply, once in force, to all algorithmic trading activities of a firm, including in respect of unregulated financial instruments, such as spot FX instruments. Where a third-country firm operates in the UK through a branch, the PRA's proposed approach to branch supervision will include a specific expectation that the third-country branch will have risk management in place that includes algorithmic trading risks.

    Comments on the PRA consultation are invited by May 7, 2018. The PRA proposes that the supervisory statement will take effect from June 30, 2018.

    Both regulators will continue to collaborate in this area to ensure their approaches remain co-ordinated. The PRA also proposes to publish a related discussion paper on operational resilience later in 2018.

    View the FCA paper.

    View the PRA consultation (PRA CP5/18).