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The European Securities & Markets Authority (ESMA) launched a consultation paper in December 2020, which seeks feedback on a number of proposed changes to MiFID II/MiFIR in relation to algorithmic trading. Of particular interest to many investment firms will be the proposed changes to RTS 6. It is expected that many firms will welcome the consultation, as it provides an opportunity to clarify regulatory expectations across a number of areas that some firms believe are not sufficiently well defined in the European regulatory standards.
The consultation is part of a legally required process in which ESMA must review and update all of the provisions of MiFID II/MiFIR relative to algorithmic trading in light of post-implementation experience and emerging concerns, with the goal of improving the current framework to operate more effectively and efficiently. Many aspects of RTS 6 are being consulted upon and if the proposed changes are implemented it will require firms to adapt their control frameworks accordingly.
From reading the consultation, we have found three areas, which we believe, will be of particular interest to investment firms engaging in algorithmic trading. These areas are related to:
However, whilst not covered here, it should be noted that the consultation paper also covers other aspects of algorithmic trading, such as the provision of Direct Electronic Access (DEA) and the management of Multilateral Trading Facilities (MTFs), which will also be important for firms engaging in those activities to consider.
Key Points ESMA are seeking to clarify:
ESMA has proposed that SIs be brought into scope for RTS 6. ESMA has also provided clarification on a number of trading processes that fall under the definition of algorithmic trading.
SIs are defined as “investment firms which, on an organised, frequent systematic and substantial basis, deal on own account by executing client orders outside a trading venue”. Trading done on SIs is considered to be Over-The-Counter (OTC) trading. However, ESMA’s view is that OTC trading by Sis can risk the overloading of trading systems, the risk of generating erroneous orders and the risk of overreaction to market events.
In this respect, ESMA has noted that SIs are employing increasingly sophisticated technology and that the volume of trading conducted on SIs is steadily growing. ESMA is therefore proposing that the MiFID definition of algorithmic trading be extended to include trading conducted on SIs and that some of the requirements currently set out in RTS 6 be selectively applied. In ESMA’s view, this would help to ensure that the activities of SIs are not a source of risk either for the SI itself or for the market as a whole.
Many firms employing SIs already have trading algorithms, which are in-scope for RTS 6, and some may already be capturing the algorithms used by their SIs in their algorithm inventories. Those firms will already have experience with the risk and control requirements that may become relevant for SIs; however, others will have work to do to appropriately capture such algorithms, their associated risk profiles, required controls and monitoring capabilities. ESMA has also provided some background as to how different parts of MiFID II will need to change to incorporate SIs coming into scope which are worthy of further consideration.
ESMA has proposed that firms submit their annual self-assessment to the regulator on a bi-annual basis and that they do so in a standardised format.
One of the most impactful proposals is that of changing Article 9 of RTS 6. The proposal is that RTS 6 should be amended to require that self-assessments be submitted to regulators. Currently firms are only required to provide a self-assessment if specifically requested by the regulator. In doing this, ESMA has opted for a more “ambitious” approach towards the self-assessment process, which would include a review element by the National Competent Authority (NCA). The self-assessment will require more information on testing environments and system controls. The expectations of the new self-assessment will be clearly specified within RTS 6.
With these new obligations, ESMA has stated their intentions for the self-assessment to shift away from being something akin to an “annual return” to more of a “due diligence” conversation with the regulator. This exercise would take place biannually instead of annually, as there is an appreciation that this new type of assessment would be more thorough in nature. The performance of stress testing, however, would still be required on an annual basis. These changes would fundamentally change the relationship between the Investment Firm and the NCA. The greater scrutiny and harmonisation from ESMA could be viewed as an attempt to end the MiFID II RTS 6 ‘honeymoon’ phase – which is not surprising, given that it has been in force for over three years now.
ESMA has proposed that firms’ approach to algorithmic trading testing and validation should be improved to better address “behavioural testing” of algorithms.
ESMA has proposed to make several clarifications and amendments relative to the ‘behavioural testing’ of algorithms. This encompasses testing to ensure that a firm’s algorithms do not behave in an unintended manner, do not contribute to disorderly trading conditions, continue to work effectively in stressed market conditions and allow the algorithms to be switched off if necessary.
ESMA has also noted that currently, there is the lack of consensus among firms as to how testing relative to disorderly trading conditions should be performed. As a starting point, they clarified in the consultation that they consider disorderly trading conditions to refer to “a market where the maintenance of a fair, orderly and transparent execution of trades is compromised” and they have proposed to include that definition in MiFID II as an amendment to the main MiFID II text.
ESMA has also proposed to produce additional guidance, which sets out their expectations as to how behavioural testing should be done and identifies some of the specific elements that should be included in testing. They indicated that the guidance should help to clarify the conditions or scenarios that should be tested and to focus the testing on the interaction between the algorithm and the market. EMSA is proposing to develop this guidance in the Level 2 text (RTS 6).
ESMA has also proposed that firms be required to report the specific testing environments that they use for each algorithm in their RTS 6 annual self-assessment. Further to this, ESMA has suggested that delineated methodologies for algorithmic testing and development need to be established. This will ensure that testing environments will be included within the Article 9 self-assessment. Firms will now be required to assess their own testing environments, which will enable the application of different approaches to testing algorithms depending on the specific trading system used.
Changes to the testing regime are seeking to provide greater clarity and guidance to firms conducting testing of their trading algorithms, as well as to improve general quality of testing performed. ESMA are seeking to accomplish this through adding detail and clarity to the existing regulation, so that firms’ approaches to testing are coherent across the single market.
In its recent consultation, ESMA has made a number of proposals aimed at improving the current framework set out in MiFID II/MiFIR in relation to algorithmic trading. Key amongst these for investment firms are proposals to bring SIs under RTS 6, redefine the Article 9 self-assessment and improve the nature of algorithmic testing and validation. These proposed scope changes align to a general theme of extending RTS 6 and its requirements to promote greater coherency of the regulation and more robust regulatory oversight.
ESMA’s proposals are open to consultation until 12 March 2021. We expect to know more about the direction ESMA wants to take, following industry feedback, around the start of H2 2021. We encourage firms to read the consultation carefully and consider its impacts. We would welcome a conversation with industry participants who wish to discuss the consultation with us further.
Mark is a Partner in our Regulatory Assurance team. He is our AI Assurance, Internet Regulation and Global Algorithm Assurance Leader with 20 years of experience across financial services audit and assurance, regulatory compliance, regulatory investigations and disputes. He has led the development of our assurance practice as it relates to our approach to assisting firms gain confidence over their algorithmic and AI systems and processes. He has a particular sub-sector specialism in the area of algorithmic trading with varied experience supporting firms enhance their governance and control environments, as well as investigate and validate such systems. More recently he has supported and led our work across a number of emerging AI assurance related engagements.
Barry is a Director in our Banking & Capital Markets Audit and Assurance Group in London and has over 15 years’ experience spread across industry and financial services. Barry has led several large projects specifically focused on enhancing our clients AI & Algorithm control frameworks and assessing their design and operating effectiveness to ensure full regulatory compliance.