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Markets and Securities Services | Issue 46
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Algo traders: governance requirements
Chapter I of the RTS prescribes the following
organisation requirements for firms engaged
in HFT and algorithmic trading: clear
accountability lines, including procedures to
approve the development, deployment and
updating of algorithms; effective procedures
for the communication of information
within the firm; the separation of risk and
compliance functions from trading desks to
ensure that unauthorised trading activity
cannot be concealed.
The RTS also require a firm’s compliance
function to have a general understanding of
how the firm’s algorithms operate and require
continuous contact between compliance staff
and the personnel with detailed technical
knowledge of a firm’s algorithms (including
with the person who has access to the
algorithm’s “kill functionality”, a technical
safety valve that effectively lets the firm
immediately cancel all unexecuted orders in
relation to an algo).
The RTS also set out controls that apply
when the compliance function (or elements
of it) is outsourced to an external provider
and requires the firm itself to employ a
sufficient number of adequately trained staff
to manage the firms’ algo systems. These
staff members themselves need to understand
the systems, how they are monitored,
the underlying trading strategies and the
firm’s legal obligations in connection with
algorithmic trading. The RTS require that risk
and compliance staff have sufficient authority
to challenge the algo trading specialists
where trading gives rise to disorderly market
conduct or to suspicions of market abuse.
Algo systems: testing and deployment
Chapter II of the RTS sets out detailed and
extensive requirements relating to the
testing and deployment of algorithmic
trading systems. These rules require firms
to establish development and testing
methodologies to ensure that algorithms
function properly (including in stressed
market conditions), that they conform with
the requirements of the RTS and trading
venue rules, and that they do not contribute
to disorderly trading conditions.
The rules also stipulate ongoing conformance
testing to check that algorithms continue to
function correctly and in accordance with
the requirements of a trading venue or DEA
provider, as and when circumstances and
conditions change, for example when there is
a material change to trading venue rules or a
material change that affects the functionality
of a DEA provider. The RTS mandate that all of
these testing and development requirements
operate in a dedicated testing environment
that is separated from the actual trading desks
where algorithms operate from day to day.
Before any algorithm is deployed in a “real-
world” environment, a firm must also set
predefined limits on the number of financial
instruments traded by the algo, the price,
value and number of orders, the strategy
positions, and the number of trading venues
to which orders are sent. Once the system
is in operation, pretrade controls on order
entry require firms to apply price collars and
maximum order values and volumes, and
maximum message limits to allow the system
to reject orders that don’t fit within the
range of these predefined values. The rules
also require the application of automated