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Regulatory responses to algorithmic trading

Written by Marsha Parker

Regulatory responses to algorithmic trading

A New Regulatory Challenge

Algorithmic trading has always been a contentious issue. The use of machines to generate profits at otherwise unfathomable speeds and frequencies raises a number of ethical questions – not to mention regulatory challenges.

With the COVID-19 pandemic frustrating the trading of instruments via conventional manual methods, little has changed for trading algorithms. It’s this continuity and ease of application that has seen automation come to account for over 50% of activity across many markets. As the Reserve Bank of Australia put it: “It is likely that the COVID period will have only furthered the industry’s shift toward electronic trading.”

As regulators turn their attention towards algorithmic trading, firms should carefully monitor developments and adjust their processes to ensure compliance.

What is algorithmic trading?

Algorithmic trading is defined by the UK’s Financial Conduct Authority (FCA) as ‘trading in financial instruments which meets the following conditions:

  • Where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission; and
  • there is limited or no human intervention.’

The problem with algorithmic trading

As with many other areas of life, automation is set to become a significant part of equities trading and investing. When applied properly, algorithms can make for a highly efficient approach to investment research and while facilitating rapid trading execution. Beyond this, algorithms can also be used to minimise the market impact of large trades since they ease the burden of subdividing orders.

Despite the benefits brought by algorithmic trading, there are also concerns that a lack of proper controls could lead to market manipulation. The FCA’s 2018 Algorithmic Trading Compliance in Wholesale Markets report expressed concern that unconstrained AI algorithms could make the ‘logical’ decision to engage in market manipulation to maximise profits.

Other potential issues have been raised in legal proceedings such as those brought by the NYSE in response to the SEC’s approval of a new mechanism for trading stocks via a particular exchange. Evidence filed in the case pertains to the issue of whether protecting automation undermines the reliability of the markets while harming millions of retail investors. The NYSE deems its case necessary to protect investors from predatory’ algorithmic trading strategies, and it seems likely that regulation in this area will become more complex regardless of the outcome.

How have regulators responded?

As with any shift in the markets, the rise of automated trading has not gone unnoticed by regulators. In December 2020, the European Securities and Markets Authority (ESMA) issued a consultation paper on automated trading with a view to bringing the Markets in Financial Instruments Directive (MiFID II) framework up to speed with current trends.

Similar actions have been taken by bodies across the world, and it’s quickly becoming apparent that regulation of algorithmic trading is firmly on the agenda. While the international picture is broadly one of consultation to gain a better understanding of this form of trading’s impact, some regulators have gone further and faster.

Regulation in Asia

In Asia the Hong Kong Monetary Authority (HKMA) commenced a review of automated trading activities in 2019. The resultant supervisory expectations document suggests that all firms should align their policies with those of the regulator when using automated trading strategies. Put more simply, firms are expected to develop policies around governance, oversight, and post-trade controls while keeping a comprehensive inventory of algorithms.

The principle (rather than rules-based) approach taken by the HKMA is far from unique and takes its lead from the EU’s MiFID II Regulatory Technical Standards (RTS) 6. The exception is the addition of an annual self-assessment requirement for Hong Kong firms, which illustrates the willingness of regulators to impose new compliance obligations in this area.

Elsewhere in Asia, regulators continue to study the use of automation and its impact on markets. The Bank of Japan (BoJ), for instance, has published its own findings on the effect of algorithmic trading on market liquidity and has committed to deepening its understanding of the topic.

Regulation in America

In the US, the fracas between the NYSE and the Securities and Exchange Commission (SEC) was preceded by a report from the regulator detailing the need for “continued vigilance in monitoring these advances in technology and trading.”

While the SEC appears to be more ambivalent towards algorithmic trading than some of its international counterparts, the report did conclude that the “updating of systems and expertise will be necessary in order to help ensure that our capital markets remain fair, deep, and liquid.

It remains to be seen how the NYSE case will pan out, but additional regulations are certainly a possibility in North America.

Regulation in Europe

With ESMA’s consultation not due to be submitted to the European Commission until July 2021, the picture in Europe is likely to remain the same for some time to come. The MiFID II regime already imposes robust compliance requirements on firms engaging in automated trading activity, and it is unlikely that the consultation will lead to a relaxation of these rules.

In the UK, MiFID II was largely transposed into domestic law ahead of Brexit. This means that firms under the FCA’s jurisdiction must continue to engage with the rules including by conducting real-time monitoring of all algorithmic trading activity that takes place under their trading code.

Looking to the future, it seems that the FCA will follow in the footsteps of its EU counterpart by investigating the need for further regulation. The regulator has been vocal on this matter in the past with its Director of Market Oversight, Julia Hoggett, commenting in 2019:

I can see a world where seemingly ‘rational’ AI, unconstrained and exposed to certain markets and data, would deem it entirely rational to commit market manipulation. Now, the FCA cannot prosecute a computer, but we can seek to prosecute the people who provided the governance over that computer.”

Keeping up with the regulators

With international regulatory authorities keeping a close eye on automated trading practices, it seems almost inevitable that further compliance obligations will arise for listed companies and firms operating in the equities trading sphere.

Algorithmic trading undoubtedly has its benefits, but firms must be careful to keep their activities in step with laws and guidelines. eflow’s TZ platform helps businesses to cope with these challenges and provides a single solution for trade surveillance, transaction reporting, and a range of other essential legal responsibilities.

To find out more, book a demo below or contact eflow today.