Out-Law News 1 min. read

UK regulators to tighten rules around algorithmic trading


Financial firms engaged in algorithmic trading will be required to allocate oversight of this activity to named senior managers, the Prudential Regulation Authority (PRA) has announced.

The policy forms part of a formal risk management and governance framework for algorithmic trading, published by the PRA for consultation. The new rules incorporate governance arrangements, firms' approval processes, testing and deployment, inventories and documentation and risk management.

The PRA's consultation closes on 7 May and the new rules are expected to come into force on 30 June to coincide with new European Banking Authority (EBA) guidelines on the topic.

Publication of the consultation coincided with a new report by the Financial Conduct Authority (FCA), setting out its supervisory priorities in relation to algorithmic trading and examples of good and bad practice. The FCA said that automated trading "brings significant benefits to investors, including increased execution speed and reduced costs". However, the technology can also "amplify certain risks".

"In general, we are encouraged that firms have taken steps to reduce risks inherent to algorithmic trading," the FCA said in its report.

"However, further improvement is needed in a number of areas. For example, some firms lacked a suitable process to identify algorithmic trading across their business and did not have appropriate documentation in place to demonstrate suitable development and testing procedures are maintained. In these cases, firms also lacked a robust and comprehensive governance framework," it said.

Algorithmic trading is a type of trading where initiation, generation, routing or execution is carried out by a computer without human intervention, usually at high speeds. The regulators are concerned that the speed of this activity means that the risks associated with the underlying transactions could be "amplified" without appropriate governance arrangements in place.

The PRA will expect the firm's governance body to explicitly approve its algorithmic trading governance framework, and to identify which senior management functions within the business will have responsibility for this activity. Firms should have a robust algorithm approval process and test the algorithm thoroughly, with testing carried out "at a frequency, and with a level of rigour, commensurate with the risks the firm could be exposed to".

The firm's risk management and systems and controls functions should understand and have oversight of the risks associated with its algorithmic trading activity, while the firm should also have and maintain algorithm and risk control inventories, according to the consultation. The firm's risk management function should have the authority to challenge existing risk controls, and to impose additional requirements on algorithmic trading where appropriate.

The framework set out in the PRA's draft incorporates new algorithmic trading requirements set out in the EU's recast Markets in Financial Instruments Directive (MiFID II) and Regulation (MiFIR). It will apply to all regulated firms regardless of whether the algorithmic activity itself is regulated, so will apply to algorithmic activity associated with unregulated spot foreign exchange instruments.

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