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FCA warns trading algorithms can add ‘extreme events with wide-spread implications’ to markets

On Monday, the Financial Conduct Authority (FCA) warned that the increasing use of trading algorithms could turn manageable market incidents into ‘extreme events with potential wide-spread implications’. In a report titled ‘Algorithmic Trading Compliance in Wholesale Markets’, the financial watchdog said that while automated technology can increase execution speed and reduce costs, it can also amplify certain risks. As a result, it said it is essential that key oversight functions like compliance and risk management keep pace with technological advancements. Is this a remotely realistic goal?

In its report the FCA warned, ‘in the absence of appropriate systems and controls, the increased speed and complexity of financial markets can turn otherwise manageable errors into extreme events with potentially wide-spread implications,’

Algorithmic trading is the process of using computer programmes to follow defined sets of trading instructions, which allows them to place profit-generating trades at a rate impossible for humans.

The process has many benefits, such as ensuring trades are carried out at the best possible prices and reducing the rate of human error, but also risks increasing volatility during times of stress often to the detriment of the whole market.

In its assessment of algorithmic trading, the FCA noted a number of examples of good and poor practice ahead of the implication of pan-European regulatory directive MiFID II at the beginning of January. Although it said it was encouraged by the steps companies had taken to reduce risks, some organisations lacked a suitable process to identify algorithmic trading across their business. It added that some also did not have appropriate documentation in place to demonstrate that suitable development and testing procedures were being maintained.

‘In these cases, firms also lacked a robust and comprehensive governance framework,’ it said.

The FCA also found that businesses need to do more work to identify and reduce potential conduct risks created by their algorithmic trading strategies.

These include delivering suitable market abuse training for staff in these departments and considering the potential impact that their algorithmic trading activity may have on the fair and effective operation of financial markets.

In order to combat these concerns, and ensure that algorithmic trading meets requirements laid out by MiFID II, the FCA has laid out its five key areas of focus. These are:

-To ensure firms establish an appropriate process to identify algorithmic trading,

-To ensure firms maintain robust, consistent and well undertook development and testing processes,

-To ensure firms develop suitable and robust pre-and post-trade controls,

-To ensure firms maintain an appropriate governance and oversight framework, and,

-To ensure firm appropriately consider the potential impact of their algorithmic trading on market integrity.

Megan Butler, director of supervision for investment, wholesale and specialist at the FCA, said: ‘This report is relevant for all firms developing and using algorithmic trading strategies in wholesale markets. Firms should consider and act on its content in the context of good practice for their business.’

As laudable as the intentions behind the FCA’s report are, the reality is it is unlikely to have a meaningful impact on the behavior of market participants. With so much money to be made from algorithmic trading it is highly unlikely that any attempt to encourage firms to self-regulate their behavior will be met with much success. What is much more probable is that in the modern trading environment, when markets experience the high volatility we’ve seen over recent weeks, extremely sharp moves higher and lower will continue to become more pronounced as the “algos” kick in.

 

Author

Daniel Flynn

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