Index. FIA EPTA Principles. 5. Risk Controls. 1. Introduction

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2 Index 1. Introduction 2. General Description 3. Prevention of Market Manipulation 3.1 Hiring of Employees 3.2 Training of Employees a. Internal Training b. External Training 3.3 Software Development and Change Management 4. Detection of Market Manipulation 4.1 Monitoring a. Trading b. Post-Execution and Back Office 4.2. Post-Trade Review a. Tools to Detect Market Manipulation b. Possible Alerts c. Data Requirements d. Recordkeeping e. Timing 4.3. Internal Review 5. Risk Controls 5.1 Access & Oversight a. Change Management & Testing b. Conformance Testing c. Error Control 5.2 Pre-Trade Risk Management a. Pre-Trade Risk Limits b. Price Collars c. Fat-Finger Quantity Limits d. Repeated Automated Execution Throttle e. Outbound Message Rate f. Kill Button g. Market Maker Protections 5.3 Trading Interruptions a. Heartbeats Among System Components b. Emergency Notification Procedures c. Back-Up Execution Facilities 5.4 Post-Execution and Back Office a. Post-Trade Limits b. Order Fill Validity c. Reconciliation d. Software Release Management ANNEX FIA EPTA Principles 2 FIA EPTA - July 2012

3 FIA European Principal Traders Association Market Integrity Framework: Best Practices to Preserve Market Integrity Fig.1: The diagram above depicts the different actions identified by FIA EPTA members to prevent and detect market manipulation and mitigate risks. The experience gathered by a firm in its efforts to detect market abuse and monitor risks (left side) is used to adjust and improve the preventive measures (right side). 1. Introduction Technological developments have significantly altered the trading landscape over the past few years. While these changes have brought significant efficiencies and other benefits to the market, they have also introduced new sources of risk to trading firms. Members of Futures Industry Association European Principal Traders Association (FIA EPTA) are major providers of liquidity on regulated trading platforms and counterparties to a large percentage of trades on these platforms. Thus, they are strong supporters of fair and transparent markets that remain free from trading practices that negatively affect the integrity of these markets. In order to become a member of FIA EPTA, applicants must agree to support FIA EPTA principles (see Annex). FIA EPTA - July

4 To emphasize the importance of the preservation of market integrity, FIA EPTA has developed these best practices to assist firms in their efforts to prevent and detect market abuse and mitigate risks. These best practices build upon existing European regulation in general and ESMA s guidelines on systems and controls in an automated trading environment 1 in particular. They should be read as a set of recommendations from FIA EPTA to trading firms and provide guidance to firms in establishing their internal policies and procedures and/or Codes of Conduct. Because many of the issues touched upon (e.g. risk controls) also have direct economic implications, firms will often have policies and procedures that expand upon those recommended in this document. Given the different jurisdictions in which members operate, their individual size and the distinct strategies employed, the extent to which these provisions should apply will vary. For this reason, firms should incorporate these best practices on a proportional basis. Finally, although the term best practices is used in this paper, it should be noted that best practices have and continue to evolve. It is, therefore, important that trading firms periodically evaluate their policies and practices and update them as appropriate. Similarly and in line with the ESMA Guidelines, firms are encouraged to keep adequate records that assist them in evidencing adherence to their specific policies and procedures. These best practices reflect once more the commitment of FIA EPTA members to actively prevent, detect and report market abuse and to manage the risks related to their trading activities. 2. General Description Market manipulation has long been prohibited under national and EU law. Recently ESMA issued further guidance on the application of the current prohibition under the Market Abuse Directive (MAD). Accordingly, all firms are currently required to implement measures to prevent and detect market manipulation. The FIA EPTA supports well-regulated markets. A market structure based on empirical evidence, as opposed to anecdotal evidence, facilitates transparency, stability and integrity to the benefit of all market participants. Indeed, managing the risks associated with market access is a critically important responsibility of all parties involved in the process, including clearing firms, exchanges, and trading firms. A market that is free from manipulation is fundamental to fostering stability. Importantly, each market participant is obligated to refrain from market manipulation. Regulated firms are also responsible for establishing a culture and practices that prevent, detect and deter manipulation. Changes to the definition of market manipulation in MAD are being discussed at the EU level. Firms may be required to modify their internal practices to incorporate these changes. 1 ESMA, ESMA Guidelines on Systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities, 22/12/2011, Final-report-Guidelines-systems-and-controls-automated-trading-environment-trading-platforms 4 FIA EPTA - July 2012

5 FIA European Principal Traders Association Market Integrity Framework: Best Practices to Preserve Market Integrity Market manipulation can be characterized by any of the following: 1. Transactions or orders that give a false or misleading signal or secure the price of a financial instrument at an artificial level; 2. Transactions or orders that employ fictitious devices and/or other forms of deception or contrivance; and 3. Distribution of information likely to give false or misleading signals. Although FIA EPTA acknowledges that at least in some jurisdictions market manipulation may not necessitate intent, it is FIA EPTA s view that a practice should only be classified as manipulative when undertaken with intent. 3. Prevention of Market Manipulation FIA EPTA members as major providers of liquidity to the regulated markets, as well as counterparties to a large percentage of trades, have a strong incentive to prevent abusive practices from occurring in the market. As such, they endeavour to create a compliance culture within their firms that act as a deterrent against abusive practices. References in this document to compliance or compliance staff may not always strictly refer to a specific department designated as compliance. Instead they may, depending on the size of the company and local regulatory requirements, refer to other employees or systems fulfilling such functions. 3.1 Hiring of employees Firms should use due diligence in choosing new employees. Adhering to the general Markets in Financial Instruments Directive (MiFID) requirements, firms should operate under risk based hiring standards. Firms should apply standards that take into account the department and role a new employee will have. Particularly stringent hiring criteria should be placed on staff who perform key tasks in the risk management and monitoring of trades. FIA EPTA recommends that a firm s hiring process include a background check of the applicant as well as a criminal records check, especially in terms of criminal offenses related to market manipulation and trading. The process also should take into account the previous employment history and education of the applicant and exchange qualifications to the extent relevant. Depending on the applicant s background and function within the firm, he or she may be required to complete a range of training exercises designed to provide sufficient knowledge of market regulations and prohibited trading practices. Additionally, some jurisdictions place additional requirements on the hiring process and will require new employees to register with the relevant regulatory authority and/or exchanges. 3.2 Training of employees Firms should ensure that, once hired, new employees receive appropriate training in their roles, and that all employees are subject to on-going refresher training programmes, when appropriate. Staff training typically consists of internal training, which may be, complemented by external training exercises. FIA EPTA - July

6 a. Internal Training Firm training for its employees is one of the main contributors to creating a work environment that prevents manipulative practices. A firm s training process begins from the point that a prospective employee receives an employment offer. The hiring process should refer to compliance training and documentation to which the employee will be required to adhere, including rules regarding prevention of market manipulation. In addition, if a firm has a written code of conduct, employees should be required to familiarise themselves with and agree to abide by it. On commencement of their roles, employees should be required to complete training programmes that include the regulatory requirements applicable to the firm s business and employees responsibilities to act consistently with these requirements. Training should be tailored to suit the needs of the employees, depending on the department in which they work. Firms may also consider assigning new employees a mentor from the senior staff to provide a contact point for questions. New employees should also be supervised more closely in the first few months to ensure that they understand all rules and regulations. Training is, however, not only relevant for new employees, but also existing ones. Given that rules and regulations are in a constant state of flux, employees will have to be made aware of changes relevant to their work. Firms, therefore, should consider when it is appropriate to require employees to attend training and refreshment courses, especially pending implementation of significant regulatory changes. In order to continuously demonstrate suitability as well as expertise, firms will maintain training records. b. External Training In addition to internal training, firms should also consider when it is appropriate to take advantage of external training opportunities for their employees. This training may include certification through trading venues, and training and qualification from other organisations recognised by local authorities. 3.3 Software Development and Change Management Firms that trade using Electronic Trading Systems (ETS), will develop procedures for software development, testing, and change management Detection of Market Manipulation In addition to the steps taken to prevent market manipulation, principal trading firms should also incorporate measures to detect market manipulation. Detection measures could include a combination of monitoring on a near real-time intraday basis, reviewing post-trade and periodic internal review. 2 FIA PTG EPTA Software Development and Change Management Recommendations futuresindustry.org/downloads/software_change_management.pdf 6 FIA EPTA - July 2012

7 FIA European Principal Traders Association Market Integrity Framework: Best Practices to Preserve Market Integrity Unless algorithms are specifically designed to prevent market abuse, firms may want to implement automated alert systems to flag behaviour likely to trigger suspicion of market manipulation. Such alert systems should be in place for all orders transmitted, including orders that are executed, modified or cancelled. Market data is not necessarily required to flag suspicious trading activity. For this reason, firms should store all orders transmitted, but may decide not to retain market data. 4.1 Monitoring a. Trading Staff responsible for monitoring the operation of the ETS should report any trading not compliant with their firm s policies and procedures to the individual(s) responsible for such compliance. b. Post-Execution and Back Office Firms should strive to maintain timely and accurate trade and account information by reconciling their own electronic trading logs with records provided by their brokers, clearing firms, or other business partners as soon as practicable. In satisfying this objective, firms should consider segregating trading and back office roles and responsibilities in such a way that an individual cannot conceal unauthorised trading activity. 4.2 Post-trade review a. Tools to Detect Market Manipulation Firms should not only take preventive action against market manipulation, but they should also have internal controls in place to maintain compliance with all applicable rules and regulations. Since market abuse may not always be prevented on a pre-trade basis 3, firms should have the ability to identify suspicious trading behavior and report these events to responsible staff on a post-trade basis. On receiving such a report, responsible staff should investigate to determine whether the trading activity constitutes a legitimate trading behaviour or could be considered market manipulation. b. Possible Alerts Depending on the nature of the activities of a firm and the markets in which the firm trades and is registered, a firm should consider the value of implementing alert systems as part of its compliance program. The purpose of an alert system is to detect activity that may require further investigation by internal staff and is an important component of an effective anti-manipulation scheme. Any alert system will necessarily be over-inclusive, flagging some number of entirely valid orders or trades. 3 ESMA Guidelines on systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities, Guideline 6(3)(c) FIA EPTA - July

8 FIA EPTA recognises that the ESMA Guidelines on Systems and Controls in an Automated Trading Environment set out a number of examples of potentially manipulative behaviour. Specifically, the guidelines highlight ping orders, quote stuffing, layering and spoofing and momentum ignition as practices that have the potential to constitute market manipulation. FIA EPTA strongly believes that these practices only result in market manipulation if there is intent to manipulate the market. FIA EPTA is not convinced that there is widespread use of these practices for market manipulation and believes that evidence about practices such as pinging, quote stuffing and momentum ignition for the purpose of market manipulation continue to be anecdotal. Nevertheless, firms must be alert to patterns of trading suggesting this behaviour both at the design and monitoring stage, and conduct appropriate diligence and analysis to investigate the circumstances and intention surrounding such trading to determine whether it risks infringing upon applicable market manipulation laws and/or the rules of trading venues. Firms should consider whether to supplement their internal policies and procedures with an alert system designed to monitor for instances of potential market manipulation. A firm that determines such an alert system is appropriate, may benefit from using certain statistics or metrics to flag behavior warranting further review such as message counts, repetitive orders, and small or large orders. Automation is a tool that can be used by firms in addition to manual monitoring procedures. Thresholds for automated alerts should be determined by relevant staff based on experience and knowledge of how a firm s ETS works. It is also suggested, but not required, to weight the alerts, so that staff can focus on evaluating alerts with a high weighting. Of course, as mentioned above, reviewing personnel should assess, based on the facts and circumstances, whether the metrics appropriately identified intentional manipulative conduct or inadvertently captured legitimate trading behavior. Firms should have procedures in place to ensure that orders and transactions that are investigated and that could constitute market manipulation are reported to the competent authorities as soon as possible. c. Data Requirements In addition to retaining data required by relevant regulatory bodies, firms may find it beneficial for troubleshooting purposes to retain all details of each order transmitted including, but not limited to: 1. Product 2. Side (Buy/Sell) 3. Price 4. Time stamp (execution/update, inserts) 5. Quantity 6. Order type 7. Symbol 8. Venue 9. Additional details, if applicable, depending on product (e.g. put/call, strike price) 8 FIA EPTA - July 2012

9 FIA European Principal Traders Association Market Integrity Framework: Best Practices to Preserve Market Integrity d. Recordkeeping Firms should retain for retrieval all orders transmitted, including orders that are executed, modified or cancelled, for a minimum of 5 years 4. e. Timing Reports that are generated by alert systems should be available for review by responsible staff on the following trading day or according to the schedule set out in their internal review procedures. 4.3 Internal Review Principal trading firms should adopt an internal review function in order to assess the effectiveness of their risk management and compliance practices and controls. Since principal trading firms operate in different legal landscapes with different legal, compliance and risk management requirements, the scope, purpose and objectives of an internal review function may vary significantly. Furthermore, the size, as well as the nature of the activities of the firm will impact its approach to this function. For example, some firms may delegate this responsibility to other types of assurance-like roles and some may outsource this role. Other firms, especially larger ones, may have an external and/ or internal review function embedded in their organizational structure. 5. Risk Controls 5.1 Access & Oversight ETSs should be monitored at all times while operating in the markets. Staff must have training, experience and tools that enable them to monitor and control the trading systems and troubleshoot and respond to operational issues in a timely and appropriate manner. Firms should have policies and procedures for ensuring that the appropriate staff involved in supporting electronic trading operations have the necessary authorizations with relevant trading platforms, brokers or clearing firms to provide the appropriate level of support. a. Change Management & Testing Any changes to the production environment should be subject to review by a responsible party within the organization. The depth of the review should reflect the magnitude of the proposed change. b. Conformance Testing Trading firms are typically required to pass conformance testing with the party providing access when implementing a new direct access system or when a platform provider deems it necessary because of a fundamental change in platform functionality. The onus is on the trading firm to determine when it must recertify due to a change in logic within their system. We would encourage exchanges and other market infrastructure providers to collaborate in order to provide robust and more complete test environments to ensure the most appropriate testing facilities are available to firms. 4 See FIA Market Access Risk Management Recommendations, April 2010 at org/downloads/fia-mkt_access_risk_mgmnt(lr).pdf FIA EPTA - July

10 c. Error Control Trading firms should have procedures that direct the actions of traders, ETS trading monitors and support staff in the event of a trading system error. The procedures should be aimed at evaluating, managing and mitigating market disruption and firm risk and should identify people to be notified in the event of an error resulting in violations of the risk profile, or potential violations of trading platform rules. FIA EPTA suggests that it would be helpful for trading venues to collaborate with regard to error trade policies in order to harmonise procedures, and to adopt a Preferred Adjust-Only Policy. 5.2 Pre-Trade Risk Management Trading firms should set pre-trade risk controls where it makes the most sense for the security of the firm and for the orderly operation of the markets; in addition, there should be robust and transparent pre-trade risk controls within trading venues. a. Pre-Trade Risk Limits Trading firms should establish and enforce pre-trade risk limits that are appropriate for the firms capital base, clearing arrangements, trading style, experience, and risk tolerance. These risk limits can include a variety of hard limits, such as position size and order size. Depending on the trading strategy, these limits may be set at several levels of aggregation. b. Price Collars Trading systems should have limits on the price of the orders they can send, configurable by product. This limit should prevent any order for a price outside of the price collar from leaving the system. c. Fat-Finger Quantity Limits Trading systems should have upper limits on the size of the orders they can send, configurable by product. This limit should prevent any order for a quantity larger than the fat-finger limit from leaving the system. d. Repeated Automated Execution Throttle Automated trading systems could have functionality in place to monitor the number of times a strategy is filled and then re-enters the market without human intervention. After a configurable number of repeated executions within a configurable timeframe the system should have the functionality to be disabled until a human re-enables it. e. Outbound Message Rate Trading firms should monitor the number of order messages their trading systems send to a trading venue in a given period of time. These limits should be in line with trading venue rules and the trading firm risk tolerance. f. Kill Button Trading systems could have a manual kill button that, when activated, disables the system s ability to trade and cancels all resting orders. 10 FIA EPTA - July 2012

11 FIA European Principal Traders Association Market Integrity Framework: Best Practices to Preserve Market Integrity g. Market-Maker Protections Firms with specific market-making obligations should be aware of and, when appropriate, utilise any market-maker or sweep protections provided by a trading venue. Market-maker or sweep protections are parameters set by market makers and implemented by the trading venue to provide a degree of risk protection by limiting the market-maker s quote execution exposure. When a market maker s defined protection values are met or exceeded within certain time intervals, the protections are triggered and any new messages from such market maker would be rejected and resting quotations cancelled. FIA EPTA believes that trading venues should provide a level of protection for market makers who quote simultaneously on both sides of the market. 5.3 Trading Interruptions a. Heartbeats Among System Components Electronic trading systems should monitor connectivity heartbeats among their various components as well as with the trading venue to identify when connectivity to any system component or the platform has been lost. If key connectivity is lost, the ETS should be disabled and working orders reviewed by the system operator or cancelled through any trading venue-provided cancel-on-disconnect functionality. b. Emergency Notification Procedures Trading operations staff should have contact details for incident response personnel responsible for relevant technical and market operations staff internally, at third-party vendors and at applicable trading venues. c. Back-Up Execution Facilities Trading firms could have procedures and arrangements for alternative trade execution methods in the event that their primary systems or direct market access fail. Measures could include alternate electronic execution platforms (for example via trading venue, clearing firm or ISVprovided platforms) or non-electronic alternatives such as broking desk phone numbers or clearing firm provisions. When trades are executed through alternative methods, firms should have logs documenting the execution of such trades and recording the relevant trade details. 5.4 Post-Execution and Back Office a. Post-Trade Limits Trading firms should also establish and automatically enforce post-trade risk limits that are appropriate to the firms capital base, clearing arrangements, trading style and risk tolerance. For example, a trading firm can set daily loss-limits by instrument, asset class and strategy and automatically close-out or reduce positions if those limits are breached. b. Filled Order Validity Trading firms should monitor their filled order messages that are received from the trading venue to confirm they are valid. Validity can be determined by a number of trade specific factors and action should be taken to investigate any discrepancy. FIA EPTA - July

12 c. Reconciliation ETSs or associated firm systems should have functionality to accept drop-copies from trading venues and clearing firms. Drop copies are copies of orders that allow a firm to compare the trading venue or clearing firm view of trades and positions with the systems internal view. This helps to assure that all systems are performing as expected and maintaining accurate and consistent views of trades and positions. The drop-copy data may also be used by risk managers to view their firm s risk exposure independently of the trading system. d. Software Release Management The best practices provided herein should be considered in conjunction with the FIA Principal Traders Group (PTG) and FIA EPTA Software Development and Change Management Recommendations released 14 March This document was created by a joint working group of the FIA PTG and FIA EPTA. ANNEX FIA EPTA Principles Regulation: FIA EPTA members believe that well-regulated markets provide stability and create efficiencies. For this reason, market participants and trading platforms should be appropriately regulated. Stability: FIA EPTA members believe that stable, reliable and well-functioning markets increase security and safety and provide the foundations that encourage investor confidence. FIA EPTA members support mechanisms that increase stability in the market, for example, the use of central counterparty facilities. Transparency: FIA EPTA members believe that markets should strive for real transparency for investors and market participants, both pre and post trade. Trading of standardized over-thecounter products should take place on organised trading venues in order to provide increased transparency to the market and regulators. Risk management: FIA EPTA members believe in having risk controls in place to help ensure orderly, safe and secure markets. Competition: FIA EPTA members believe that fostering competition between market participants, trading platforms, clearing platforms and co-location facilities is necessary for encouraging innovation and promoting market efficiencies. Equality of access: FIA EPTA members believe that access to markets should be open to all, non-discriminatory, and provided at a reasonable cost to market participants in order to minimise barriers to entry and increase competition. Equality of information: FIA EPTA members believe all market participants should have access to the same trading information in order to provide a level playing field. Efficiency: FIA EPTA members believe in the most efficient markets. Technological innovation drives changes in market structure that make markets more efficient and competitive, benefitting participants and leading to a better result for the end investor. Integrity: FIA EPTA members believe that firms should operate with integrity in the market, and communicate with regulators in an open and honest way. 12 FIA EPTA - July 2012