Self-assessment algorithmic trading: room for improvement

MiFID II and RTS 6

MiFID II

MiFID II, in force as of 3 January 2018, brought about important changes in the market structure of European capital markets by introducing rules on algorithmic and high-frequency trading. Algorithmic trading is trading in financial instruments where a computer algorithm automatically determines the individual parameters of orders. Examples of these parameters are the initiation, timing, price and size of the order. The algorithm also determines how the executed order will be managed. This is done with little or no human intervention.

A specific subset of algorithmic trading is high-frequency trading, where a trading system analyzes data or signals from the market at high speed.  In respons to that analysis, it sends or updates large numbers of orders within a very short time period.

RTS 6

Under Article 17 MiFID II (‘Algorithmic Trading’), the European Commission (EC) adopted Commission Delegated Regulation 2017/589 of 19 July 2016 (RTS 6). RTS 6 is based on draft regulatory technical standards submitted to the EC by the European Securities and Markets Authority (ESMA), specifying the organizational requirements of investment firms engaged in algorithmic trading. Pursuant to Article 9 of RTS 6 (‘Annual self-assessment and validation’) investment firms engaged in algorithmic trading shall annually perform a self-assessment and validation process and on the basis of that process issue a validation report. In the course of that process the investment firm shall review, evaluate and validate its:

1. algorithmic trading systems, trading algorithms and algorithmic trading strategies;
2. governance, accountability and approval framework;
3. business continuity arrangement; and
4. overall compliance with Article 17 MiFID II, having regard to the nature, scale and complexity of its business (i.e. proportionality principle).

The validation report shall be audited by the firm’s internal audit function, if such function exists, and be subject to approval by the investment firm’s senior management.

First self-assessments analyzed by the AFM

Algorithmic trading in financial markets is one of the core areas of focus for the regulator, the Dutch Authority for the Financial Markets (AFM). Investment firms that engage in algorithmic trading in the Netherlands have to notify the AFM, but this specific information is not included in the registers published by the regulator.

In 2019, the AFM analyzed the self-assessments of twenty proprietary trading firms under its supervision. The regulator’s overall analysis of these self-assessments has identified three ‘Key Areas of Attention’:

• the information provided was often insufficient to properly understand the effectiveness of the controls in place;
• governance appeared to be not embedded within several organizations as per the requirements of RTS 6; and
• the IT-security controls overall appeared to be substandard.

The AFM’s observations with regard to these attention areas are followed by recommendations:

• use clear and detailed (control) descriptions, substantiate proportionality (‘comply or explain’) and use the template available on the AFM website (optional);
• segregate duties and document key approvals; and
• make IT security part of the Risk Framework and perform penetration and vulnerability scans.

In the context of the first recommendation, a control description should state how the control is designed and operating in practice. It should address important questions like who does what, when and how, and where is the result/supporting evidence documented. With respect to the second recommendation the AFM refers to the RACI-model, used to avoid confusion over roles and responsibilities: who’s Responsible?, who’s Accountable?, who’s Consulted? and who’s Informed? And, as also stated in the Trend Monitor 2020, cybersecurity and operational IT are risks that the AFM will explicitly keep on its supervisory agenda.

Supervision of algorithmic trading in 2020

At the end of its analysis, the AFM briefly touches upon its supervision of algorithmic trading firms in 2020:

• algorithmic trading will be a focus area;
• self-assessment request may be part of supervision;
• considering similar approach or deep dive approach; and
• other investment firms engaged in algorithmic trading may be in scope as well.

What can Charco & Dique do for you?

Would you like to improve your own annual self-assessment and validation process? Please contact us without obligation, we are happy to offer you advice. Our expert and independent quick scan of your validation and/or audit report can contribute to confidence that your algorithmic trading operations are sound and well controlled. Please do not hesitate to get in touch.