Firms operating in trading markets are increasing the use of algorithms activities. Driven by the rise of electronic platforms and availability of data, algorithms are often used for making both execution and investment decisions.
It is essential that key oversight functions, including compliance and risk management, keep pace with technological advancements.
There are 28 Regulatory Technical Standards within MiFID. RTS 6 warrants special attention and requires firms to annually perform a Self-Assessment and validation process when they engage in algorithmic trading activity.
The five main RTS 6 tenets are:
- Defining and capturing: the creation of a repository to document algorithms, including those from third parties, as well as all changes made to these algorithms.
- Development and testing of algorithms: detailed documentation of development steps as well as testing protocols and results of all trading and risk management algorithms.
- Risk controls: both pre- and post-trade controls are required. Pre-trade controls may include market and credit risk limits, maximum order volumes, automatic execution throttles and price collars. Post-trade controls should sit within both the 1st and 2nd lines of defence (i.e. operational management and risk management/compliance, respectively) and focus on the monitoring of pre-trade controls. Kill switch functionality is also required.
- Governance and oversight: it is vital that compliance actively participates in developing and deploying of algorithmic trading software and that reporting lines are clearly delineated. Ultimately, senior management must be accountable for the controls. Conflicts of interest should be clearly avoided and training must be thorough and kept current.
- Market conduct: the Market Abuse Regulation (MAR) obligation is reinforced in terms of monitoring behaviour associated with illegal use of algorithms (e.g., pinging). The regulation specifies that firms must conduct real-time monitoring and regularly review their automated alerts to minimize false positives and negatives.