The Trap

As many firms get to grips with the MiFID II/MiFIR rules, some are realising that the burden of “owning” an algorithm will be significantly higher on 3rd January 2018 when the legislation comes into effect.

However, the first surprise for many was the breadth of what is considered an algo by the European Commission. To quote the original MiFID II text:

So that includes execution algorithms, pricing algorithms, market making algorithms, auto-hedgers and even Smart Order Routers (although some standard order routers are excluded). If some of these are simply implemented on a worksheet in Microsoft Excel, that’s included too!

The concept of “ownership” needs to be carefully considered as well. MiFID’s Regulatory Technical Standards are explicit about the rules still applying even if a firm outsources development and/or operation of its algos to a 3rd party… (this shouldn’t include transmitting an order to another firm using their algo to trade on a trading venue using their participant ID).

The Consequences

So what happens if your firm falls under the algo rules.

One of the principal requirements is to keep a register of all Algorithms in use at the firm and to notify both the local regulator and trading venues they are used on about their use.

Then RTS 6 goes into more detail with 4 main areas:

General Organisational Requirements

The first set of regulatory requirements lay down how ESMA expects firms to organise themselves to ensure the firm as a whole takes responsibility for the use of algos: from development of new algos through to monitoring of production algos.

  • Segregation of Roles & Responsibilities: As well as mandating clear lines of accountability between the development/testing teams and the trading desk using the algos, the regulation is also looks for clear separation between these functions.
  • Independent Monitoring: While algo traders are used to monitoring their own algos today, MiFID II raises the bar by demanding that the larger firms have an independent compliance function to monitor these algos too.
  • Knowledge & Authority: If this independent compliance function is to monitor these algos, they are also expected to understand what the algos do, what monitoring alerts mean, have the authority to challenge the trading floor and even demand that algos are switched off.

Pre-Deployment Requirements

MiFID II now makes demands on how Algos are built and tested before they are put into production as well as constraints on how algos are rolled into a live environment.

In particular, the RTS is quite prescriptive on the level of testing, so, in addition to testing to ensure algos connect to trading venues and operate correctly, there are specific requirements to test that algos don’t contribute to “disorderly market conditions”.

Records must be held on all changes to algos too, with audit trails that can identify who made the change, who authorized the change, the nature of the change and when the change was implemented.

Finally, before any algo can go into production, a representative of a firm’s Senior Management Team must sign-off that it has been appropriately tested and complies with the rules of MiFID II – Again, the ESMA are keen to see accountability all the way up to the top.

Post-Deployment Requirements

Even after deployment, there are on-going requirements to assess and monitor the use of algos, even if no changes are made, starting with an annual validation report:

Annual Testing

Every year, each firm using algos will need risk management teams to review and evaluate their use of algos, the management and procedures governing their use, assess how effective business continuity arrangements are and attest to compliance with MiFID II rules for Algorithmic Trading.

ESMA again expects accountability right up to the top of the firm and this time Senior Management board must sign off the annual report.

As part of the review, each algo will need to be stress tested to ensure that it remains capable of handling peaks in market activity and should be able to cope with at least twice the highest message & trade rate seen over the previous 6 months.

Change Control

ESMA’s RTS 6 also requires an authorisation process that must be followed if production algos need changing or updating, again referring to the appropriate sign off by a responsible individual nominated by the senior management team.

Resilience & Control Requirements

ESMA has specific control requirements that must be built into every algo:

  • Kill Functionality – As mentioned, both the trading floor and compliance teams must be able to switch off an algo but in addition to that, it must ensure that the firm can cancel any or all un-executed orders as well.
  • Monitoring – Every Algo must have the appropriate real-time monitoring and automated alerting built in to the production environment capable of detecting anomalies and disorderly market conditions.
  • Market Abuse Monitoring – In line with all other trading activity, algos must also be monitored to ensure that they are not being used to manipulate markets. Although this requirement doesn’t demand real-time alerting, any suspicious trading activity must be identified by the beginning of the next trading day.
  • Price Collars, Order Limits and Position Limits – As expected, controls over how far a price can be set from the market price and the maximum size of orders need to be built in and set appropriately.
  • Market & Credit Risk – In addition, post-trade monitoring must be able to provide feedback into the algo to ensure a firm has effective control over its market and credit exposure.
  • Message Rate Limits – Controls that limit the message rate must be built into algos and trading systems to ensure that trading venues are not overwhelmed by messages potentially causing disorderly trading conditions.
  • Access Permissioning – There must be strict control over who has access to use algos.

Business Continuity plans must also be factored into the design and management procedures for trading systems and algos. In line with good practice, ESMA expects that procedures are reviewed and tested at least annually.

Addressing the regulatory demands

As you can see above, there is a significant burden on firms using algos to trade with strict requirements on organisational structure, knowledge, algo functionality, algo monitoring and validating that all of this works.

Algo Inventory and Release Management

Factoring organisational change with clear lines of responsibility will be a matter of a firm’s organisational design, but capturing their activity as algos are designed, developed and put into production can be effectively managed and recorded in Sycamore Financial Technology’s Algo Inventory and Release Management Service.

Algo Inventory and Release Management Service

As well as maintaining a comprehensive register of algos and their status, the service is designed to orchestrate the wider organisation to comply with the various aspects of managing an algo from concept, development, test and into production and any post-production activity such as annual stress tests and validation reports.

With an “out-of-the-box” solution, firms can quickly enable the service on-demand and rapidly integrate into the firm’s environment securely.

Apart from helping with compliance with MiFID II/RTS6, firms will also bring other important benefits including greater visibility over the algo development and test process and, because the system is event driven with automatic notifications, firms will be able to drive change to algos faster through their organisation as well.

Scenario Testing – Normal Market & Disorderly Trading Conditions

The Flash Crash of May 2010 might have been triggered by an algo taking a significant chunk of liquidity out of one market, but it was other algos in the same market that amplified and contributed to the deepening of the crash not just in one market but across a number of markets. It is this effect that the regulators are looking to avoid and why they have mandated that disorderly market testing is conducted.

That is where AlgoGuard comes in. This is the only commercially available product that can truly simulate markets. It not only replays historical market scenarios, it can also simulates the true liquidity that sits behind the market provided by other market participants under both normal and disorderly market conditions.

AlgoGuard provides a realistic multi-market simulation which can test algos to assess whether they respond correctly when markets are stressed or disorderly and even go so far as to provide a pass/fail opinion.


The rapid testing capabilities of AlgoGuard will allow firms to carry out mandatory testing much more effectively and efficiently.

Algo Monitoring

Finally, as mentioned before, while Traders may be used to monitoring their-own algos, MiFID II will now require Compliance teams to monitor the same algos.

That represents a challenge for the Compliance teams: without the trading expertise, they will need to have more help to understand when an algo is working correctly and when it is not.

Sycamore Financial Technology’s Algo Monitoring infrastructure monitors algos in real-time. However, what sets this product apart from other solutions, is the intuitive user interface that allows non-expert Compliance staff to quickly identify alerts as they appear and investigate with drill downs into the detail.

The Algo Monitoring user interface will quickly identify the issue and also provide convenient access to key information such as the trader responsible for the algo and associated strategy documents. This can empower compliance teams to quickly challenge the trading floor with the relevant information as MiFID II requires.

With a convenient set of algo management solutions, Sycamore Financial Technology can quickly change these regulatory challenges into an operational benefit for your firm.

Get in contact with us to learn more.