Under the spotlight: The implications of the FCA’s proposed new oversight strategy for principal trading firms

The Financial Conduct Authority (FCA) has given firms until the end of the month to consider its recommendations; firms are not required to report their actions back to the regulator.

The FCA’s ‘supervisory strategy for Principal Trading Firms (PTF)’ letter – circulated to chief executives last month – highlighted five key areas of focus for the regulator for the next two years. The TRADE takes a look at what the FCA’s planned strategy means for the market empirically.

The recent communication follows the previous Wholesale Broker Letter (WBL) and addresses the key risks which could arise in relation to PTF’s, what drives them, and the FCA’s expectations for these firms in mitigating these risks.

Not all elements of the letter apply to all firms, understandably, however, the FCA has directed chief executives to discuss the points outlined with their respective boards, consider how the outlined risks could apply to their business, and make a plan to manage them effectively, by the end of September 2023.

The letter states that firms must have agreed actions or next steps in relation to the points relevant to their operations, however, there is no formal requirement for firms to report this back to the FCA.

Instead, firms are expected to be able to clearly demonstrate, if required, how their approach will work to meet the FCA’s expectations, as well as proving its suitability in contributing to the consistent overall framework and in addressing broader resilience requirements.

The supervisory strategy, informed by the regulator’s recent supervisory experiences, specifically outlines five key areas: algorithmic trading controls, financial resilience, market disruption arising from commodity market volatility, operational resilience, and Brexit impacts.

One of the key takeaways gleaned from the strategy letter related to managing risk in terms of algorithmic trading controls, with the FCA making it clear that it is up to the firms themselves to ensure that they are effectively resourced to handle situations which could arise in this vein.

“We expect firms to devote appropriate resources to maintaining effective oversight functions and controls aimed at reducing the impact of any trading incidents on the orderly functioning of the markets they operate in, including where firms deploy AI systems,” asserted the regulator.

The FCA further added that it expects firms to show exactly how they are tailoring their controls and system processes in line with the scale and complexity of their operations.

In terms of what’s to come, the regulator – building on findings from a 2018 review regarding algo trading controls – confirmed a future multi-firm review aimed at mitigating risk was on the cards. All PTF’s are subject to the UK’s implementation of Mifid and specifically the review will centre on firms’ compliance with Mifid RTS 6 (specific requirements governing investment firms working in algo trading), as well as a on ‘selected elements’ of Mifid RTS 7 (requirements for trading venues which enable algo trading).

In the case that these reviews find that there are material weaknesses or non-compliance, the FCA will act it has been confirmed.

The ‘supervisory strategy for PTF’ letter also made clear that – aside from firms ensuring they are themselves sufficiently resourced, and firms acting proactively in taking action against market abuse risk – it is unequivocally the responsibility of senior management at these firms to take accountability.

The regulator is focused on developments in emerging technologies and senior management should not overlook the impact of potential matters stemming from automated systems and models.

Furthermore, in terms of financial resilience, the FCA recognised the relevance of black swan events and how stress-testing is arguably not going far enough considering the current climate, where ‘unprecedented’ events are more prevalent.

Discussing their recent observations, the regulator explained: “In many instances the stress was greater than the severe but plausible scenarios firms had based their modelling on.”

Taking this into consideration, the letter suggests that firms should focus on expanding the scope of stress scenarios, explaining that events which could feasibly be labelled ‘extreme but plausible’ now encompasses far more than in the recent past.

Elsewhere, the supervisory strategy addressed the operational side of PTF’s, reminding relevant firms that they have until 31 March 2025 to ensure that they are complying with the FCA’s operational resilience rules, established in 2021.

“We expect firms that are in scope of our operational resilience policy statement to consider how they will embed the requirements and ensure they operate within their impact tolerances as soon as reasonably practicable,” said the FCA.

In terms of what this means for firms, the FCA has confirmed plans to review implementation plans – with the expectation that those ‘in-scope’ are able to demonstrate an approach which “integrates broader resilience requirements into a coherent overall framework.”