It is time now for traders to take a closer look at an IT infrastructure used to support trading decisions. What for? Do you think that you have nothing common with the algorithmic trading technique? You may be wrong...
Algorithmic trading may seem a distant concept for many market participants, in particular they may consider legal rules regulating this trading technique as not relevant.
This view may, however, not occur true in every instance.
Per definition, trading is classed as algorithmic where the system makes decisions (other than only determining the trading venue or venues on which the order should be submitted), at any stage of the trading processes including at the stage of initiating, generating, routing or executing orders.
Algorithmic trading encompasses not only the automatic generation of orders but also the optimisation of order-execution processes by automated means.
What should attract traders’ attention is the fact that in the light of the above definitions even relatively simple algorithms can qualify as algorithmic trading.
Such simple algorithm qualifing as algorithmic trading is the one which makes quotes replicating the prices of the trading venue (ESMA’s example).
Investment decision algorithms that do not initiate orders or the timing, price or quantity of an order appear to be on the safe side - when it comes to the definition.
However, the problem is that even such systems do not qualify as algorithmic trading under MIFID II, regulators underline that there is a good practice to subject such algorithms to the analogous systems and controls.
Such an approach captures every algorithm used to support trading decisions and, inevitably, requires firms to identify and make inventory of all such IT infrastructure.
Further, firms must properly classify this infrastructure as:
- algorithmic trading or
- other systems subject to analogous requirements,
and develop all necessary procedures.
Firms need to develop processes to identify algorithmic trading across the business, they must also to establish processes to capture all new algorithms, trading systems and strategies on an ongoing basis, as well as any material or substantial changes to existing ones - said the UK FCA in the document of February 2018 “Consultation Paper, Algorithmic trading” (CP5/18).
Identifying on an ongoing basis “any material or substantial changes” to existing algorithms may pose another challenge.
Some differentiations may be helpful in the above uneasy task.
It has been acknowledged by the regulator that if an investment firm merely transmits a client's order for execution to another investment firm who uses algorithmic trading, the transmitting investment firm is not engaged in algorithmic trading.
Moreover, note the critical difference between Smart Order Routers (algorithmic trading) and Automated Order Routers (beyond algorithmic trading):
- Smart Order Routers (SORs) use algorithms for optimisation of order execution processes that determine parameters of the order other than the venue or venues where the order should be submitted;
- Automated Order Routers (AOR) - devices only determine the trading venue or venues, the order is submitted without changing any other parameter of the order, including modifying the size of the order by "slicing" it into "child" orders (in case the same unmodified order is sent to several trading venues to ensure execution and it is executed in one of these venues, the functionality can also cancel the unexecuted orders in the other venues without qualifying as algorithmic trading).
Given the rapid development of artificial intelligence it can be expected, however, regulators can see increasing difficulties in keeping pace.