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Pre-trade risk & compliance checks

By JOHANNES FREY-SKÖTT, VICE PRESIDENT ENGINEERING AGENCY TRADING APPS, ITIVITI
December 12, 2017
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The risks associated with sponsored DMA access have long been understood. A practice that began life in the US, many European execution venues now allow buy-side firms to trade directly on their platforms under the sponsorship of their prime broker.

MiFID II aims to formalize rules around risky electronic orders and algorithmic trading, to boost investor confidence in financial markets and to avoid potentially abusive market behaviors that could result in disruptions like the Flash Crash of 2011. To this end, MIFID II requires investment firms to put in place flexible pre-trade risk controls, and to flag their algorithmic orders.

These controls need to apply business rules to ensure risky orders are blocked, perform pre-trade analysis to ensure market rules are being adhered to, and incorporate appropriate price discovery. Another important aspect of the requirement is the need for a so-called ‘kill-switch’ that enables firms to stop trading if they detect anomalies.

Under MiFID II, brokerage firms will be required to monitor and manage their clients’ exposures under a sponsored access arrangement, since they – the brokers – are ultimately responsible for clients’ trades executed under such an arrangement. As a result, the ability to manage buy-side risk – pre-trade and in a multiple prime brokerage environment – will become an important challenge and differentiator for sell-side firms. Any broker capability in this area will also need to take account of each individual venue’s rules and policies for sponsored access and other enhanced DMA services.

Relatedly, MiFID II will require trading firms to flag their use of algorithms and to adopt effective testing frameworks for the algorithms they deploy. Firms will be required to understand what constitutes an algorithm, and whether that includes aspects of their smart order router (SOR) functionality, for example. The new regulation goes further than before by insisting firms understand the impact their algorithms will have on the marketplace, including the reaction of other algorithms active in the segment.

Much of the focus in this area will be on execution venues to provide facilities for members and their clients to test the impact of their aggressive and non-aggressive trading algorithms in realistic market conditions. While the venues – exchanges, MTFs, OTFs – will need to make necessary arrangements, possibly with third-party providers, financial institutions will also need to commit to and demonstrate use of such facilities.

Download our MiFID II white paper

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