“Algorithmic Trading” – will you know it when you see it?

“Algorithmic Trading” is a Certification Function

“Algorithmic Trading” is one of the Certification Functions defined under SYSC 27.7.3R.?As such, any ‘Algorithmic trader’ qualifies as a “Certification Employee” and is subject to the full gamut of Certification Regime requirements, such as fit and proper testing, regulatory references and the FCA Directory.

So, if you are going to fully comply with the SM&CR, you need to be able to identify your “Algorithmic Traders”.?However, this is easier said than done.?The definition of “Algorithmic Trading” is wider than one might expect – it’s certainly not restricted to the traditional image one might have of a “trader”.?

Let’s take a closer look.

What is “Algorithmic Trading”?

The essence of “Algorithmic Trading” is that it involves the trading of a “financial instrument” through the use of a computer algorithm, where there is little or no human intervention in the process.?Broadly, a “financial instrument” includes (a) transferable securities, (b) money-market instruments, (c) UCITS, (d) options, futures, swaps, forward rate agreements and other derivatives, and (e) financial contracts for differences.[1]

More specifically, “Algorithmic Trading” is defined as trading in financial instruments where:

1.??????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

2.??????there is limited or no human intervention.

Unfortunately, there is no guidance as to what “limited” means in this context.

It does not matter whether an algorithm is developed internally or procured from a third party – it still qualifies as an “Algorithm”.[2]?Moreover, “Algorithmic Trading” is NOT limited to high-frequency algorithmic trading[3] (a method of trading that uses computer algorithms to transact very large numbers of orders in a very short period of time based solely on market conditions).?

So far so good, but this is all very high level.?Is there anything a bit more detailed? Well, yes.

Each of the following constitutes “Algorithmic Trading” for the purposes of the SM&CR:

1.??????approving the deployment of a trading algorithm;

2.??????approving the deployment of PART of a trading algorithm;

3.??????approving the deployment of an AMENDMENT to a trading algorithm;

4.??????approving the deployment of an AMENDMENT to PART of a trading algorithm;

5.??????approving the deployment of a COMBINATION of trading algorithms;

6.??????having significant responsibility for the management of monitoring (e.g. testing, stress testing or validation[4]) as to whether or not a trading algorithm is, or remains, compliant with the firm’s obligations (both regulatory obligations and the rules of the trading venue(s) to which the firm’s trading systems are connected); and

7.??????deciding (including through testing, stress testing or validation[5]) whether or not a trading algorithm is, or remains, compliant with the firm’s obligations (both regulatory obligations and the rules of the trading venue(s) to which the firm’s trading systems are connected).[6]

This begs the question “what is a “trading algorithm”?”?The FCA (rather unhelpfully) simply defines a “trading algorithm” as “a computer algorithm used in Algorithmic Trading”.[7]?However, we do know that a system that is only used for the purpose of routing orders to one or more trading venues or the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions DOES NOT constitute “Algorithmic Trading” (presumably as there is no ‘trading’ aspect to the activity).[8]

“Approving” and “deciding”

In terms of what is meant by “approving” or “deciding” in relation to “trading algorithms” – the FCA recognises that an approval or a decision may involve sign-off from different people about different aspects of the decision or approval.?In these circumstances, ALL individuals who have given an approval or made a decision (with respect to their particular aspect of the “trading algorithm”) will be regarded as performing the “Algorithmic Trading” Certification Function.[9]

Conversely, if different people (of different levels of seniority) are providing an approval or decision with respect to the same aspects of the decision or approval, only the most senior decision-taker will be regarded by the FCA as having given the approval or decision (and, therefore, be performing the “Algorithmic Trading” Certification Function).[10]?There is, however, one exception to this rule.?Where the firm’s procedures do NOT require the more senior person to carry out a detailed review of the decision of the more junior member of staff, BOTH the junior and the senior person will be regarded by the FCA has having given the approval or decision (and, therefore, be performing the “Algorithmic Trading” Certification Function).[11]

“Deployment”

What does it mean to ‘deploy’ a “trading algorithm”??In simple terms, a “trading algorithm” DOES NOT have to have actually generated actual order flows in order to have been ‘deployed’ (although it must be CAPABLE of doing so).?On the contrary, a firm may have ‘deployed’ a “trading algorithm” even though:

1.??????it has not actually been used in the generation or acceptance of orders in the past (even though it was capable of being used to do so); or

2.??????it is not actually being used in the generation or acceptance of orders at that point in time (even though it is capable of being used to do so); or

3.??????it is not currently being used in the generation or acceptance of orders because the circumstances have not arisen for it to start doing so (even though it is capable of being used to do so).[12]

It logically follows that a firm will not be considered by the FCA to have ‘deployed’ an algorithm if the algorithm is not yet capable of generating or accepting orders because, for example, it is still in development.[13]?

If a “trading algorithm” is deployed on a trading venue on which the firm has not traded before, it will still be considered to have been “deployed” (and so “Algorithmic Trading” for the purposes of the SM&CR would have taken place) if the firm is already using the “trading algorithm” on a different trading venue (as long as it is capable of generating or accepting orders).[14]

So, “Algorithmic Trading” has the potential to capture more members of staff than one might think.?We’ve tried to capture all of its moving parts in the flow diagram below.?Hopefully, this is useful.?If you have any questions – on “Algorithmic Trading” or SM&CR more generally, drop us a line at [email protected].?We’ll be happy to help.

Are you an “Algorithmic Trader”?

[1] See Part 1 of Schedule 2 to the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544)

[2] SYSC 27.8.32G

[3] SYSC 27.8.25G

[4] SYSC 27.8.27G

[5] SYSC 27.8.27G

[6] SYSC 27.8.23R

[7] SYSC 27.8.24R

[8] MiFID, Article 4(1)(39)

[9] SYSC 27.8.28G

[10] SYSC 27.8.29G

[11] SYSC 27.8.29G

[12] SYSC 27.8.30G

[13] SYSC 27.8.31G

[14] SYSC 27.8.26G