It has been said that COVID-19 has exposed and in some cases sped-up existing long-term trends. In the case of algorithmic trading, there is no exception. The operational challenges associated with the trading of instruments reliant on human intervention have been a headache for many banks and trading houses alike, particularly as many of us have shifted increasingly to remote working. For trading algorithms, it has mostly been business as usual. This fact has not escaped regulators – with the Reserve Bank of Australia saying in a recent publication: “It is likely that the Covid period will have only furthered the industry's shift toward electronic trading”
Regulators have begun to understand that higher volumes of trading by algorithms are increasingly contextualising the post-COVID capital markets. Algorithmic trading activity accounts for more than 50% of overall trading in many markets, and even up to 70-80% in other more mature markets like US Equities. Far from being a quiet year, 2020 has actually seen regulators re-focus their efforts onto algorithmic trading.
This focus has not been isolated to certain regions or geographies. We have seen a range of regulators across the globe publish reports, guidance and regulations pertaining to algorithmic trading activities. From Hong Kong, Japan and Australia, to the United States, we are starting to see the move towards heightened regulation, with more output on the horizon in 2021.
This blog summarises that shift of regulators back onto algorithmic trading – and then sets out what this means for your firm.
REGULATORY FOCUS: ASIA
Turning first to Asia, the HKMA (Hong Kong Monetary Authority) undertook a review of algorithmic trading activities in 2019. In March this year we saw the results of that review in the form of a ‘supervisory expectations’ document. The HKMA expectations are very similar to that of MiFID II RTS 6, expressing practices that firms should follow across four key areas: Governance & Oversight, Development Testing & Approval, Risk Monitoring & Controls and Documentation.
The reports adopts the principles based approach to regulation that we saw in RTS 6, rather than a rules based approach. Much of the HKMA expectations are nearly identical to the provisions laid out in RTS 6, with the big exception of the requirement for an annual self-assessment. Although, annual reviews are still required to evaluate the performance of algorithms and adequacy of systems and controls. Firms who have previously implemented RTS 6 provisions into their risk and control framework will likely find that they can leverage work they have previously done in the EU and apply it to their Hong Kong operations.
Further east, published in August 2020, the Bank of Japan (BoJ) recently undertook a comprehensive review into FX spot trading by algorithms and their impact on market liquidity. This review was primarily in response to concerns that liquidity could be detrimentally impacted by the market stress induced by the COVID-19 pandemic. The report found some evidence of some impacts to market liquidity, albeit temporary in nature. In response, the BoJ review has highlighted the need for a continued ‘deepening [of] the understanding of evolving algorithmic trading’ and noted that the FX Global Code is being reviewed this year in the context of algorithmic trading.
REGULATORY FOCUS: NORTH AMERICA
Across the Atlantic and also published in August this year, the SEC put out a report on the risks and benefits of Algorithmic Trading in US Capital Markets. This report has been submitted to the US Congress and gave an assessment on the “how and in what ways” algorithms have had an impact upon price discovery, liquidity and volatility in capital markets. The commission went on to conclude, “…updating of systems and expertise will be necessary in order to help ensure that our capital markets remain fair, deep, and liquid”.
The SEC report may well be a precursor to additional regulation in the US on algorithmic trading, although the direction that this future regulation might take is unclear.
HOW TO RESPOND?
Given the fragmented regulatory landscape globally, many international firms have found it challenging to build an algorithmic trading control framework that meets requirements across regions. Some firms have adopted their European control frameworks as a global framework, given that there are already regulatory similarities between Hong Kong, the UK and the EU - with MiFID II (RTS 6) often being seen as the most comprehensive of regulatory expectations in this space. Of course, firms taking this approach need to be mindful of local regulations specific to certain countries or jurisdictions - for example, the UK PRA’s 2018 Policy Statement sets out a supervisory statement covering UK FX Spot algorithmic trading.
Irrespective of the approach, we continue to suggest a ‘5 pillars’ approach to a global algorithmic trading control framework – the five pillars being Governance, Testing & Deployment, Algorithm Controls, Monitoring and Documentation. Indeed, many regulators have implicitly used this ‘five pillar’ approach when writing their regulation – not least the EU and HKMA. A suite of controls sits within each of the pillars that require close attention to ensure firms remain ahead of the curve for any future regulation.
The focus on algorithmic trading that we have seen this year is positive from the standpoint of reviewing the contribution such activity makes to the functioning and effectiveness of markets. We expect that in H1 2021, we will see more publications and guidance from regulators in this area and we will start to understand better the direction that the US Congress wants to take in respect of the recent SEC Report. It is currently unclear whether the US will seek to leverage the concepts within European regulation (as the HKMA has), or take a different direction altogether. Nevertheless, one thing is clear, algorithmic trading is here to stay and has been shown to be a positive force within markets. Firms should take stock of their risk and control frameworks, reviewing key documentation and continuing to undertake periodic reviews to identify any control gaps in light of emerging industry and regulatory practice. As ever, Deloitte is here to help.
…updating of systems and expertise will be necessary in order to help ensure that our capital markets remain fair, deep, and liquid.