Since the 2008 financial crisis, financial regulatory bodies have increased their regulations and surveillance of investing and trading, and automated trading is no exception. The European Commission creates rules and regulations for financial institutions throughout the European Union. Their primary directive pertaining to investing and trading is the MiFID II (the second iteration of the Markets in Financial Instruments Directive), which was rolled out in January of 2018.
In addition to the European Commission and MiFID II, the UK must also abide by the regulations and guidelines set forth by the Prudential Regulation Authority, a successor to the Financial Services Authority formed in 2016. In 2018, they released a Consultation Paper relevant to firms engaging in algorithmic trading, a Policy Statement providing feedback to responses to the Consultation Paper, and a Supervisory Statement, which also addresses unregulated financial instruments such as the spot forex market.
The stated purpose of MiFID II is to standardise practices across the EU and restore confidence in the financial industry after the 2008 financial crisis. While the first MiFID was only for stocks, MiFID II extends its scope to other financial instruments. It also imposes more reporting requirements and tests to increase transparency and reduce the use of dark pools (private exchanges where investors can trade anonymously) and OTC (over the counter) trading. It obliges firms to maintain trading thresholds and limits, prevent incorrect orders, and prevent breaches of MAR (Market Abuse Regulation, an EU directive effective as of 2016) or the rules of a trading venue.
MiFID II also requires financial firms using algorithmic trading to have a clear and formalised governance framework as well as sufficient, trained technical, legal, monitoring, risk, and compliance staff. Compliance staff in particular must understand algo trading and have contact with those who have access to the functionality to cancel unexecuted orders. This functionality includes “emergency kill” capacity: the ability to cancel all unexecuted orders with immediate effect.
Financial firms in the EU must also maintain pre-trade controls on order entry, monitor trading activity under its trading code in real time, and operate post-trade controls including market and credit risk. Algorithmic systems must be fully tested before deployment and deployed or updated only on the authority of a senior management designate. Firms are also required to have automated surveillance systems to detect market manipulation as well as real-time monitoring of all activity for signs of disorderly trading.
These are some of the main provisions, but the MiFID II has several other rules and regulations related to algorithmic trading that can be read here.
All of the above having been said, however, it is worth noting that the UK may not be part of the EU anymore soon due to Brexit. So will they be obliged to continue adhering to MiFID II? It is possible that the UK will decide to continue adhering to MiFID II after it withdraws from the EU, as financial firms have worked to adhere to its framework and many changes made to it were made at the request of the UK. But should the UK leave the EU and decide that they don’t want to adhere to MiFID II, they will not be obligated to do so. Prior to the no-deal Brexit which was possibly going to take place March 29th 2019 (though there is now an extension in place until October 31st), the European Securities and Markets Authority released a statement on the impact of Brexit on trading as an approach “for a temporary period to mitigate cliff-edge effects because of a no-deal Brexit.” Since a no-deal Brexit is still possible, the statement still applies.
As mentioned earlier, algorithmic trading in the UK is also subject to regulation by the Prudential Regulation Authority, which has released 3 key documents presenting the requirements of financial firms. Their Consultation Paper obliges firms to comply with regulation in 5 key areas: governance, algorithm approval process, testing and deployment, inventories and documentation, plus risk management and other systems and controls functions.
For governance, a firm’s governing body must approve governance framework for algorithmic trading and the management body must identify relevant Senior Management Function(s) responsible for algorithmic trading. Firms must also have an algorithm approval process and risk controls. Testing of algorithms must involve risk and control functions and be carried out with a frequency and rigour commensurate with the risks involved. Firms must also maintain algorithm and risk control inventories. Finally, functions must understand and oversee the risks of algorithmic trading and risk management must have the authority to challenge existing risk controls where appropriate.
The Prudential Regulation Authority also released a Supervisory Statement serving as a guide to their expectations of a firm’s risk management and governance with respect to algorithmic trading. This document includes restrictions on unregulated financial instruments such as the spot forex market (FX). The Supervisory Statement also charges Senior Management Functions with responsibility for algorithmic trading included in their Statement of Responsibility. Senior Management Functions must ensure traders understand algorithms, trading venues, and market liquidity. They must ensure traders’ access to algorithms aligns with their remit and the firm’s risk management framework as well as maintaining oversight of traders’ use of algorithms.
The firms these regulations refer to are also known as the brokers you use to trade. You may be wondering how to ensure the algo trading you do with Capitalise follows these regulations, and the answer is that it’s all dependent on the broker you use. All of the brokers currently available through our platform are compliant with EU and UK regulations except for Tradeview, and Capitalise is doing our best to work with the best in the market. That being said, it never hurts to do your own research or ask a broker you are considering trading with to ensure it is regulated.
For those of you who aren’t sure what Capitalise is, it’s an algorithmic trading platform empowering traders to automate their trades simply using plain English. All you need to do is write your strategies into the plain English interface and Capitalise monitors the market and executes your trades from start to finish.