Since the introduction of automated trading, much has changed in the operation of our markets: how to improve market structure and implement safeguards has been a key topic of conversation for both market participants and regulators for some time. This is why the report by the Senior Supervisor’s Group (a group that consists mostly of Central Banks) on algorithmic and high frequency trading, released yesterday, makes for curious reading, as this group of regulators make several recommendations for today’s markets that largely overlook the risk controls already implemented by the regulators responsible for market supervision. It seems timely, therefore, to reflect on the work that has already been done, both by regulators and participants, to make our markets safer.
In the EU the controls are embodied in two pieces of legislation: currently in the ESMA Guidelines for automated trading (2012) and going forward in MiFID II.
The ESMA Guidelines address risk management concerns both on the level of the trading firm and trading platform, for example, with requirements for both sides to contribute towards reducing the risk that “an erroneous or destabilizing order will reach financial markets.” The industry best practice on the part of the trading firms to protect against this is to utilise a suite of pre-trade controls to prevent such orders being submitted. These include controls on maximum order sizes, maximum intraday positions, a limit on the amount an individual order’s limit price may deviate from a reference price (such as the instrument’s current market price), and limits on the number of times an algorithm can execute and re-enter the market without human intervention (designed to stop an algorithm getting into an execution spiral).
As recommended in the SSG report, such controls are implemented at an organisational level, as well as at a more granular level (algorithm, trader or instrument), otherwise it would not be possible for a firm to manage and offset its own risk. This approach is again mandated by the ESMA 2012 Guidelines:
“Investment firms should be able to automatically block or cancel orders where they risk compromising the firm’s own risk management thresholds. Controls should be applied as necessary and appropriate to exposures to individual clients or financial instruments or groups of clients or financial instruments, exposures of individual traders, trading desks or the investment firm as a whole.”
On the whole, the SSG report seems to overlook the impact of these ESMA Guidelines that date back to 2012 and have been implemented by professional trading firms and other secondary market participants. For example, the report states: “However, at any institution, intraday risk controls may not be robust, reporting may not be complete or timely, or limit breaches may not be transparent to senior risk officers.” – This would be contrary to compliance with the ESMA Guidelines. The report also states: “Further, many banks’ prime brokerage businesses have algorithmic and HFT firms as clients, and the risk controls and monitoring efforts across these businesses vary widely among banks and are evolving to keep pace with this type of client activity.” – This is also incorrect: in the EU major prime brokers and DEA providers subscribe to industry best practices (for example those of FIA or FIA Europe) as well as the ESMA Guidelines.
MiFID II is set to be the most comprehensive set of trading regulations in the world. Firms and operators of trading venues will need to meet enhanced requirements for algorithmic and high-frequency trading, which build on the existing ESMA Guidelines. MiFID II hard-codes the principles of the Guidelines, requiring firms to have effective systems and risk controls, business continuity and disaster recovery arrangements, and ensure systems are fully tested and properly monitored through a robust governance structure with strong management oversight.
For example, automated trading systems will subject to a vigorous testing framework with specific steps to ensure their adequacy for the trading environment. The proposed MiFID II text (RTS 13, Section 1) includes articles on initial testing, conformance, non-live testing and controlled deployment of algorithms. This already includes “price and position limits as well as limits on the number of instruments and venues where the algorithm is deployed” detailed in the recommendations by the SSG and further requires firms to review systems on an ongoing basis.
The topic of safeguarding automated trading is also not new in the US: both Regulation SCI and the CFTC Concept Release on Risk Controls and System Safeguards for Automated Trading Environments cover exactly the topics flagged by the SSG report, including measures such as pre-trade risk controls, post-trade measures, system safeguards and other protections, applied both to market participants and trading platforms.
In fact, the SSG report, in focusing on the commitments of the participant to protect the markets, omits to consider the role and obligations of trading venues in the areas of testing and pre-trade risk management, which are a key component in protecting against systemic risk.
The report also stresses the importance of transparency around trading activities: this is one of the natural strengths of automated trading. Unlike in the pit days, every trade made under an automated system is recorded: this makes it possible, as it never has been before, for oversight at board level (of a trading firm) and also at the level of the regulator. Indeed, many of the most recent regulatory efforts to boost transparency and trade reporting (e.g. in the swaps market) have done so by newly requiring trades to be performed on electronic platforms, thereby encouraging automation.
With these regulatory works in mind, it would appear that the “strong, layered controls” the SSG recommends to strengthen the markets are already (or soon will be) covered under legislation and implemented by all those employing automated trading methods. By mandating robust risk controls and advocating transparency, regulators have, and will continue to, improve the safety and reliability of our markets: a mission that FIA EPTA whole-heartedly supports.
Therefore, we are left to wonder: could it be this report was drafted several years ago and only now dusted off for publication? That seems to be the only reasonable explanation - because had the SSG taken all these factors into account, the concerns they expressed in their conclusions would have been allayed.
 A team of financial regulators representing 10 countries and the European Union consisting mainly of Central Banks.
 ESMA Guidelines on Systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities (2012)
- FIA EPTA