Thematic assessment on pre-trade controls implemented by investment service providers engaging in algorithmic trading
In 2024, the Financial Supervisory Authority carried out a thematic assessment on pre-trade controls implemented by investment service providers that engage in algorithmic trading.
Algorithmic trading can cause risks1 to the trader and the market, which are sought to be managed and prevented in advance. Consequently, investment service providers must have pre-trade controls with which orders that mistakenly enter the service provider’s trading system are either prevented (hard blocks) or alerted (soft blocks).
The objective of the thematic assessment was to determine how investment service providers have implemented the pre-trade controls for algorithmic trading required by regulation2 3. The thematic assessment is part of a Common Supervisory Action coordinated by the European Securities and Markets Authority (ESMA).
The Finnish investment service providers that have notified the Financial Supervisory Authority in accordance with the regulations that they engage in algorithmic trading were selected as the target of the thematic assessment.
Key observations of the thematic assessment:
- On the basis of the replies to the thematic assessment, respondents had generally implemented the pre-trade controls for algorithmic trading required by regulation.
- However, substantial differences between the respondents were observed with respect to the practical implementation of the controls and the related procedures, including integration with market and credit risk limits. The differences seemed to be mainly due to the size of the respondents’ organisations and the nature and scope of the algorithmic trading carried out by them.
- Substantial differences between respondents were also observed in the governance and monitoring of pre-trade controls. One issue that drew particular attention in the responses was some respondents reporting that the second line of defence4 had only a minor role in the governance and monitoring of pre-trade controls. For some of the respondents, the compliance function did not appear to have any role in the pre-trade controls, and in one case, even risk management did not participate in any way in the governance or monitoring of pre-trade controls. In these cases, the processing of the controls and the alerts produced by them were left entirely as the responsibility of the operational level.
For further information, please contact
- Jyrki Manninen, Chief Legal Advisor, jyrki.manninen(at)finanssivalvonta.fi
- Pasi Åkerfeldt, Senior Inspector, pasi.akerfeldt(at)finanssivalvonta.fi
Annex
Report: Thematic assessment on pre-trade controls implemented by investment service providers engaging in algorithmic trading (pdf)
1 These risks include an increased risk of the overloading of the systems of trading venues due to large volumes of orders, risks of malfunctions, e.g. duplicate or erroneous orders that may create a disorderly market, and the risk of algorithmic trading systems overreacting to other market events.
2 Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (recast).
3 Commission Delegated Regulation (EU) 2017/589 of 19 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the organisational requirements of investment firms engaged in algorithmic trading.
4 The three lines of defence risk management model, in which the first line consists of employees engaging in operational activities and the management, the second line is composed of the risk management professionals, including compliance, and the third line comprises the respondent’s internal audit.