Navigating governance and controls in algorithmic trading

The Financial Conduct Authority (FCA) has recently released the ‘Dear CEO’ letter on Supervisory Strategy for Principal Trading Firms (PTFs)¹. The Dear CEO letter encompasses areas such as governance, oversight and controls to mitigate conduct and operational risks with a primary focus on the increasing complexity of algorithmic trading and emerging innovative technologies like Artificial Intelligence (AI).

The FCA’s expectations across key focus areas are outlined in the Dear CEO letter for PTFs. However, the focus of this blog is on the specific expectations in regard to algorithmic trading controls.

Senior management and boards hold ultimate responsibility for their firms’ trading activities and outcomes. They are tasked to promote strong governance and provide effective challenge on algorithmic trading risks. Policy setting, resource allocation, and culture setting are crucial leadership responsibilities. Leaders must ensure the resourcing and visibility of control functions like compliance and risk management match the scale and complexity of their automated trading.

At the operational level, firms should implement tailored algorithmic trading controls aligned to their business models. Key elements of an algorithmic governance framework include annual validation, pre-trade checks, kill switches, user training, and change control for model updates. 

Ongoing monitoring through performance dashboards, exception reports, and surveillance metrics is crucial for maintaining visibility. Transparency in documentation of algorithms, development processes, limitations, and monitoring procedures are essential to meet regulatory expectations. PTFs relying heavily on algorithms and AI have an obligation to safeguard market integrity. This necessitates proper explainability, testing, and human oversight of complex models. 

The FCA’s strategy letter outlines a two-year period of heightened supervision with a particular focus on algorithmic trading risks among others for applicable PTFs. Market abuse is an inherent driver of harm among all firms in the portfolio. Inadequate controls, poor market abuse policies, and ineffective or poor leadership from the top could result in instances of market manipulation and disruption. PTFs with a significant presence and those utilising algorithmic trading strategies, pose a heightened risk of harm due to these factors.

In the forthcoming multi-firm reviews, the FCA will assess compliance with elements of MiFID-II RTS 6 and RTS 7 requirements. These requirements cover pre-trade controls, kill switches, monitoring procedures and change management. Previous FCA examinations in 2018 uncovered weaknesses in governance frameworks, compliance monitoring and risk management of algorithmic trading at some firms. Any control gaps or deficient oversight expose firms to risks of market manipulation, disruptive conduct, and technology failures.

In summary, effective oversight, strong leadership accountability, and well-embedded controls that align with existing risks and complexities are fundamental expectations for algorithmic trading.

Conclusion and next steps

The FCA expects CEOs and boards of PTFs to discuss the contents of the letter, consider how the risks apply to their business, and take action to manage them effectively. With an intensified focus from the FCA in this area, the time for action is now.

Key takeaways for firms when addressing the requirements set out in the Dear CEO letter:

The time to act is now. PTFs must review this guidance, evaluate their risks, and address any deficiencies. The FCA will conduct a comprehensive review of compliance with MiFID requirements on algorithmic trading controls and trading venues and they will act on any material weaknesses. Strong accountability and effective controls to match the complexity of algorithmic trading are imperative to upholding market integrity. Get ahead of the curve before the FCA comes knocking.

Should you wish to discuss this topic further or require support with considering the risks posed by Algorithms and AI and the necessary enhancements to your Control Framework, please don’t hesitate to get in touch with our AI & Algorithm Assurance team here.

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1. Principal Trading firms (PTFs) are firms whose primary source of revenue is from trading (dealing) as principals encompassing various trading activities, including algorithmic trading, market-making and trading in commodities.