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The UK's Financial Conduct Authority (FCA) on Monday published its report on the supervision of algorithmic trading, which is intended to illustrate best practices and give guidance to firms considering implementing AI to automate trading operations.
The report is meant to help trading firms comply with the Second Markets in Financial Instruments Directive (MiFID II), an expansive EU directive implemented last month that introduces stringent new rules for capital markets participants, including around the use of algorithmic, also known as high-speed, trading. MiFID II defines algorithmic trading as a computer algorithm making decisions on when to initiate orders, and where there is little or no human intervention.
The focus areas of the report hint at concerns the FCA harbors about AI use in capital markets. The regulator placed particular emphasis on humans being able to intervene in an algorithm if something goes wrong, and ensuring the technology doesn’t start behaving in a way unintended by its creators. Additionally, it stressed the importance of senior management fully understanding the technology their firm is using, and being involved at every stage of its development and deployment.
The last point is likely tied to the FCA's senior management review of 2017, which concluded, among other things, that senior managers cannot use ignorance of the technology their firms leverage to claim immunity if a problem occurs. As ever-more use cases for algorithms and AI emerge in capital markets, regulators — while recognizing the benefits such automation can bring — also appear anxious about the technology evolving beyond its creators’ control and understanding.
Algorithmic trading isn't new, but it's now raising novel challenges for firms and regulators alike. High-speed trading has been a feature of capital markets for several decades, but the fact remains that AI, the technology that usually underpins such software, is now becoming rapidly more sophisticated and capable of making more nuanced decisions.
Lately, there have been several cases in which the algorithms implemented by trading companies seemed to start acting in ways unforeseen by their developers, leading to mishaps and flash crashes, notably the pound's flash crash following the Brexit referendum in 2016. As such, as the technology itself threatens ot take on a life of its own, in conjunction with many firms' lack of technical knowledge and proliferating use cases, regulators are right to want to keep an eye on such markets to mitigate risks.
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