Algorithmic Trading – The FCA Finds Shortcomings

Introduction

The FCA has recently reviewed a sample of ten principal trading firms (PTF’s) who undertake algorithmic trading, to assess their compliance with MIFID Regulatory Trading Standard (RTS) 6. RTS 6 was introduced in 2018 as part of MIFID II, specifically addressing algorithmic and high frequency trading by requiring firms to implement stringent controls over trading activities to ensure robust risk management and market stability.

In their ‘Dear CEO’ letter of August 2023 the FCA said that algorithmic trading controls would be a key area of supervisory focus for the next two years and to follow this up the FCA has recently reviewed the RTS 6 self assessments, validation reports and supporting documentation of the ten firms to consider:

• Whether firms had addressed each aspect of RTS 6.

• The quality of the self-assessments.

• The evidence supporting the firm’s conclusions.

As is their usual practice the FCA highlighted both good and poor practices and here we feature the poor practices and areas where the FCA identified room for improvement, under key headings.

Governance

Self-Assessment and Validation

The FCA found that most firms had developed a better understanding of the requirements and governance frameworks since the introduction of RTS 6 in 2018. However, at some firms, the FCA found more detail was required in certain areas of the self-assessment and identified deficiencies needed to be addressed more efficiently. This included out of date policies and unclear processes and documentation which indicated a lack of formal governance and accountability. In addition, key policy documentation was not linked or referenced in some self-assessments. In some cases, firms did not address certain elements of RTS 6 at all in their self-assessments, such as IT outsourcing and Compliance training.

Role of the Compliance Function

Firms are required to make sure that Compliance staff have at least a general understanding of how the firm’s algorithms operate. The Compliance functions of some firms did not have a strong technical knowledge of algorithmic trading. This meant the ability of Compliance staff to challenge trading behaviours was limited - this is an area where FMCR can provide strong technical training for Compliance teams.

Algorithmic Inventories

Firms should maintain a comprehensive inventory of algorithmic trading strategies and systems. The FCA found that most firms maintained complete algorithmic inventories that captured the key details of each trading algorithm. However, in some cases, the algorithmic inventory did not specify the individuals who were approved to operate the algorithm.

Deployment of Algorithms (including material changes)

It is important that firms have clear, formalised procedures for deploying trading algorithms and the management of material changes to those algorithms. The FCA found that some firms had out-of-date policies, or unclear procedures for testing and deploying algorithms. In some cases, firms had not clearly documented the definition of a material change, nor was any Management Information (MI) provided to the board regarding deployments. In some cases, firms that used third party algorithms did not have a good technical understanding of how those algorithms were developed.

Development and Testing

Conformance Testing

Conformance testing is an important element of algorithmic development and approval, and firms are required to test the conformance of their algorithms with the system of the trading venue or direct market access provider, in accordance with Article 6 of RTS 6. The FCA found that most firms were compliant with Article 6 of RTS 6 and carried out the required conformance testing. Some firms noted that conformance testing procedures differed significantly from venue to venue. Some firms, however, had poorly defined conformance testing procedures and this sometimes resulted in poor record keeping practices.

Simulation Testing

Firms must maintain testing processes to identify potential issues before deployment and make sure the algorithm behaves as intended, does not contribute to disorderly trading and behaves effectively under stressed market conditions. Simulation testing carried out by some firms lacked sophistication or did not appear to consider a wide range of market scenarios. Similarly, some firms lacked formally documented testing policies and procedures, even though testing was taking place. Many firms had strong pre-trade and post-trade controls in place on their algorithms. However, it is important that firms ensure that algorithms are tested appropriately before deployment, to make sure they do not contribute to disorderly trading conditions and continue to work effectively in stressed market conditions. It is also essential that firms’ testing capabilities keep pace with the ever-increasing speed and complexity of their own algorithms, financial markets and technological advancements including cross-asset testing, where relevant.

Controlled Deployment of Algorithms

Firms must have adequate processes to make sure algorithms are deployed in an appropriate and controlled manner. The FCA noted some firms lacked formal documented procedures for the deployment of algorithms. This was often accompanied by unclear ownership of key elements of the algorithmic deployment process.

Risk Controls

Pre/Post-trade Controls

Firms must have adequate and robust pre/post trade controls, set at appropriate levels, to identify and reduce trading risks and control trading activity. In certain cases, ownership of pre-trade and post-trade controls was poorly defined and not documented. Firms’ policies and procedures must clearly define the individuals with responsibility for managing pre-trade and post-trade controls. Also, in some cases, compliance staff had a lack of oversight of pre-trade and post-trade controls. This resulted in those compliance staff having a weak understanding of the controls and how they functioned. It is important that all firms continuously review their pre-trade and post-trade controls, as well as the governance procedures and documentation.

Market Abuse Surveillance

Surveillance Systems and Governance and Oversight

Firms must consider the potential impact of their algorithmic trading on market integrity, monitor for potential conduct issues, and reduce market abuse risks. In certain cases, the FCA noted that firms had not done enough to update or invest in their market surveillance systems. This meant their surveillance was not developing commensurately with the nature, scale and complexity of their trading activities. Moreover, some firms did not have formalised procedures or governance structures around market abuse alert investigation. This often resulted in alerts taking longer to be investigated and closed and, in some cases, the FCA also found that market abuse alert investigation and closure generated significant resourcing pressure, with a small number of staff being responsible for a significant volume of alerts.

Conclusion

Overall, the FCA found that most firms they reviewed had a good understanding of their obligations under RTS 6. There was, however, significant variation in the sophistication of firms and their level of compliance, even taking into account the nature, scale and complexity of their trading activities.

FMCR has a team of highly experienced technical trading floor professionals, with substantial hands-on experience, who can assist you with independent review of your algorithmic trading activities and provide appropriate training for your staff if required.

For further discussion and initial consultation please contact FMCR at contact@fmcr.com.