Dealers in principal under the regulatory spotlight

Dealers in principal under the regulatory spotlight

On the 4th August 2023 the UK Financial Conduct Authority (“FCA”) published its latest “Dear CEO” letter, this time setting out its supervisory priorities vis-a-vis Principal Trading Firms (“PTTs”, also known as “Dealers in principal”). As the name of the category suggests, PTTs are firms that generate much of their revenue from dealing as principal, including:

  • engaging in  liquidity provision and market making activities, including using algorithms;  
  • trading in the commodity markets; and
  • acting as systematic internalisers offering price and speed competition to trading venues. 

In fulfilling these roles, the FCA states that PTTs owe “particular responsibilities to the UK and its financial markets”. The purpose of this note is to provide a high level summary of the latest “Dear CEO” letter’s content. Some self assessment questions are also provided to help busy senior managers prepare for possible interactions with the regulator.

Takeaway 1: expect follow up work in the algorithmic trading (“AT”) controls arena

The FCA last conducted a review into wholesale firms’ algorithmic trading systems and controls in 2018. Since then, much has changed with the UK leaving the EU and artificial intelligence applications such as ChatGPT dominating the headlines. With this in mind, the FCA is gearing up to probe firms’ defences in this area again. 

Self assessment questions

  • Can your firm evidence how: 
    • it identifies and assesses the risks associated with technological developments in the trading arena? 
    • it has customised its AT systems and controls to meet the specific challenges posed by its operating environment, particularly in relation to potential misconduct? 
    • the control functions tasked with monitoring the activities of AT operations adequately resourced?
    • the board challenges senior management concerning its oversight of the deployment of trading algorithms?

Top tips

Takeaway 2: expect in-depth scrutiny of capital and liquidity planning 

The FCA commits to undertaking “targeted reviews of firms’ capital and liquidity now that the Investment Firm Prudential Regime (“IFPR”) has been introduced”. For some firms, this could signal the commencement of a Supervisory Review and Evaluation Process (“SREP”), exposing them to the full range of supervisory tools the regulator could draw upon in the event deficiencies are found. For a list of these, see MiFIDPRU 7.10.6.  

Self assessment questions 

  • Has your firm stressed its financial resilience based on “severe, but plausible” scenarios? When were these scenarios last revisited and replayed to consider latest developments in the firm’s external environment? 
  • Has your firm tested its wind down plan? Has this taken into account the likely challenges to winding down in situations of wider market stress?
  • Can your board and senior management articulate how the firm’s capital and liquidity risk management arrangements adequately reflect the financial and market risks the firm faces? 

Top tip

  • Identify the firms in your “regulatory peer group” by size, nature and scale of their activities. Obtain a copy of their latest audited accounts from Companies House. Review the commentary in the accounts. What risks are your peers claiming they are facing? Could your firm also be exposed to them? If so, is this reflected in your firm’s capital and liquidity planning? 

Takeaway 3: if your firm trades in commodity derivatives then expect more attention from the FCA

That commodity markets have experienced sustained periods of market volatility in recent times is no secret. Geopolitical events have triggered credit stresses, substantial marginal calls, liquidity strains and counterparty frailties. These features would all combine in the now infamous nickel market disruption that occurred at the London Metal Exchange in March 2022. The FCA is keen to work with firms to reduce the impact from future events of this nature on the wider financial system. Accordingly, firms should expect more questions about the information submitted in the MIF00 suite of prudential returns. 

Self assessment questions 

  • What horizon scanning does your firm conduct to identify potential signs of future volatility? 
  • How are the results of this scanning reported to your firm’s governing body and senior management? 
  • Can the firm’s governing body and senior manager demonstrate the proactive use of such information to determine if its financial resources remain adequate considering potential headwinds? 

Takeaway 4: ensure your firm is on track to meet the new operational requirements

This winter’s cyber-attack on ION Markets vindicated the FCA’s operational resilience push. Firms’ reliance on critical third party suppliers is a key area of focus for the regulator. If your firm is in-scope of the new operational resilience requirements then you can expect to be contacted about its progress in implementing them. 

Self assessment questions 

  • Even if your firm is not formally in-scope of the new requirements, has it considered their relevance from a good practice perspective anyway? This is likely to gain your firm credit in the event an operational resilience related issue materialises. 
  • If your firm is in scope of the new requirements, is it on track to implement them in good time before the 31st March 2025 deadline? Remember, in-scope firms should aim to operate within their impact tolerances “as soon as reasonably practicable” and not use the March 2025 deadline as a “target”. 

Top tip:

Takeaway 5: If your firm expects to make any further changes to its business model because of Brexit then it should inform the FCA “at the earliest opportunity”

Such changes could include:

  • entity changes;
  • staff movements; and
  • desk or function moves. 

Self assessment questions

  • If your firm is planning to restructure its business, can it demonstrate that it has considered the risks associated with doing this and how these will be mitigated?
  • If your firm is newly authorised by the FCA as a result of Brexit related changes, can it demonstrate that it has conducted a rules mapping exercise to determine what requirements it is subject to? Where it has identified gaps, is your firm proactively seeking to resolve these?

What next?

The FCA states that it expects, by end-September 2023, “all CEOs to have discussed this letter with their fellow directors and/or Board and to have agreed actions and/or next steps.”

Top tip:

  • If possible, evidence discussion of the “Dear CEO” letter at a minuted board meeting which addresses each of the points raised in this article. 

Need help?

As the cutting edge research showcased in this article demonstrates, C&G’s consultants don’t just respond to regulatory developments in the trading space, we forecast them. Please do not hesitate to contact us if you have any queries about the themes raised in this piece.

References

  1. Our supervisory strategy for Principal Trading Firms. Financial Conduct Authority, available at: https://www.fca.org.uk/publication/correspondence/portfolio-letter-our-supervisory-strategy-principal-trading-firms.pdf (last accessed 9th August 2023). 

Culley, A.C. (2023), “Does the deployment of algorithms combined with direct electronic access increase conduct risk? Evidence from the LME”, Journal of Financial Regulation and Compliance, Vol. 31(2), pp. 220-236. https://doi.org/10.1108/JFRC-04-2022-0046

Culley, A.C. (2023), “Insights into UK investment firms’ efforts to comply with MiFID II RTS 6 that governs the conduct of algorithmic trading”, Journal of Financial Regulation and Compliance, Vol. ahead-of-print No. ahead-of-print. https://doi.org/10.1108/JFRC-12-2022-0144

Culley, A.C. (2023), “Trading at the Speed of Light: How Ultrafast Algorithms Are Transforming Financial Markets,” Journal of Financial Compliance, Henry Stewart Publications, vol. 6(2), pp. 187-190, January.

Ormand, D. (2023), How to Survive a Crisis: Lessons in Resilience and Avoiding Disaster. Penguin Book Limited

MacKenzie, D. (2021), Trading at the Speed of Light: How Ultrafast Algorithms Are Transforming Financial Markets. Princeton University Press. https://doi.org/10.2307/j.ctv191kx1k

Alexander Culley

Alexander Culley

Alexander Culley