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FCA weighs in with report on algorithmic trading

The Financial Conduct Authority has identified areas of good and bad practice within algorithmic trading and has produced a report on supervision of the activity.

The U.K. financial watchdog said in its "Algorithmic Trading Compliance in Wholesale Markets" report that automated technology "brings significant benefits to investors, including increased execution speed and reduced costs." However, the FCA warned that technology can also amplify certain risks.

Therefore, it is "essential that key oversight functions, including compliance and risk management, keep pace with technological advancements."

The FCA conducted a number of cross-firm reviews on themes related to algorithmic trading and also used reviews ahead of the implementation of new rules under the Markets in Financial Instruments Directive II in its identification of good and poor practice.

Five key areas of focus were identified.

First, to define algorithmic trading, requiring firms toestablish "an appropriate process to identify algorithmic trading, manage material changes and maintain a comprehensive inventory of algorithmic trading across the business."

The second area of focus is on development and testing. The FCA report said firms should maintain robust, consistent and well-understood development and testing processes that identify potential issues across these algorithms. Under the third area of focus — risk controls — the FCA wants firms to develop suitable and robust pre- and post-trade controls to monitor, identify and reduce potential trading risks.

The fourth point, governance and oversight, requires firms maintain a framework that "demonstrates effective challenge from senior management, risk management and compliance on algorithmic trading activities." The final focus, on market conduct, carries a key objective to ensure firms "appropriately consider the potential impact of their algorithmic trading on market integrity, monitor for potential conduct issues and reduce market abuse risks," said the report.

"This report is relevant for all firms developing and using algorithmic trading strategies in wholesale markets," said Megan Butler, director of supervision–investment, wholesale and specialist at the FCA, in a statement accompanying the report. "Firms should consider and act on its content in the context of good practice for their business."