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11 Aug 2023

New FCA "Dear CEO letter" sets out wide-ranging expectations and requirements in relation to Principal Trading Firms


On 4 August 2023, the Financial Conduct Authority ("FCA") sent a "Dear CEO letter" setting out their supervisory strategy for "Principal Trading Firms" ("PTFs").  The letter sets out numerous requirements and expectations in respect of such firms. The FCA identify PTFs as firms deriving the majority of their revenue from trading as principal which may include algorithmic trading (which could be high frequency trading) and market making. The letter in a number of cases focusses in particular on firms that trade as principal in commodity markets, referring to financial derivatives, physical commodities, emission allowances and their derivatives. The FCA expect PTFs to have a plan of action and next steps to meet those expectations in place by the end of September.

The letter details the FCA's view of the most important risks arising from PTFs and their expectations of those firms, explaining its supervisory focus for the next two years. It expects the CEO and Board to discuss the letter's contents, consider how the risks apply to its business, and take action to manage them effectively.

External Environment

The FCA indicate that PTFs have been impacted by external events in recent years, including heightened geopolitical risks, Brexit, the Russian invasion of Ukraine, the current challenging macroeconomic environment, and lingering effects of COVID-related impacts. In particular, PTFs specialising in commodity market trading may have been exposed to periods of sustained volatility, high prices leading to substantial margin calls and other higher costs, credit stresses and increased counterparty risks. In addition, they say a number of incidents have underlined the importance to firms of having appropriate systems and controls in place to manage the risks to their businesses (e.g., the cyber-attack on ION Markets and the collapse of FTX, which also highlighted the unpredictable nature of crypto activity). The FCA are aware that some PTF firms are considering their approach to cryptoassets and expect firms to keep abreast of the latest thinking and approach to cryptoassets such as the February 2023 Treasury consultation issued on 1 February 2023.

Market Abuse and Volatility

The FCA identify that inadequate controls, poor market abuse policies, and ineffective or poor leadership from the top could result in instances of market manipulation and disruption. The FCA consider that PTFs that have a relatively large trading footprint, and those that utilise algo trading strategies, pose a heightened risk of harm. Many PTFs are highly technology-dependent, and an operational incident at larger firms has the potential to cause harm to wider markets. As such, all firms must ensure they are operationally resilient, including having effective cyber-security.

The FCA again point to commodity trading firms, in particular where trading supports the physical flow of commodities across their wider group, saying they can pose particular risks to their counterparties and the wider functioning of financial markets if they have dominant market positions or are large market participants. While FCA's ongoing analysis of the sector had not revealed any recent "flash crash" market events, nor evidence of widespread serious misconduct, the FCA remain on heightened alert around 3 particular (but unnamed) commodity markets. The FCA say that while many PTFs' risk, governance and compliance controls have appeared adequate in responding to recent events, a minority of firms have weaknesses in their governance and control infrastructure. For them, a "mindset change" is required.

Five key areas of FCA supervisory focus:

  1. Algorithmic trading controls. Given the inherent risks in algorithmic trading, firms’ controls and key oversight functions, including compliance and risk management, must keep pace with the ever-increasing complexity and speed of financial markets and technological advancements (including artificial intelligence). The FCA want firms to devote appropriate resources and to maintain effective oversight functions and controls, tailored to reflect the nature, scale and complexity of their business models, aimed at reducing the impact of any trading incidents on the orderly functioning of the markets. The FCA also highlight that senior management's responsibility/accountability includes outcomes arising from the use of automated systems or models. The FCA observed from their 2018 review weaknesses in some firms’ governance/oversight frameworks, compliance and risks monitoring in relation to algorithmic trading controls. They say they will now conduct follow-up work in this area including a multi-firm review of compliance with MiFID RTS 62 requirements governing algorithmic trading controls and some elements of the MiFID RTS 73 requirements in respect to trading venues. Where material weaknesses and non-compliance are identified, the FCA say they will act "to ensure risks are mitigated...".

  2. Financial resilience. FCA expect all PTFs to plan ahead and ensure sound management of their financial resources, including having robust plans in place to meet potential demands on both capital and liquidity, and to enact an orderly wind-down if necessary. They say some PTFs have more complex interactions with markets and the real economy, that being particularly true for those that operate in commodity markets, and those firms must remain vigilant as to whether their capital and liquidity risk management arrangements reflect their exposure to their financial and market risks. The FCA will undertake targeted reviews of firms’ capital and liquidity now that the new Investment Firm Prudential Regime (IFPR) has been introduced, and will take action to address any weaknesses. They say this may include business restrictions, additional "own funds" and/or liquid asset requirements, or other interventions.

    The FCA refer to their recent experience of engaging with firms that are failing or in peril, and which considered the cause of their stress to be related to "unprecedented" or "unforeseeable" events. In many instances the stress was greater than the severe but plausible scenarios the firms had based their modelling on. The FCA say that henceforth PTFs should expand the scope of their stress scenarios (including reverse stress test scenarios leading to wind-down) and plan on the basis that their own wind-downs are likely to be made more complex by surrounding stressed environments. These may well affect firms’ ability to trade and to realise assets at expected value and may also involve the non-availability of suppliers. The FCA add that it "is very likely that the scope of events covered by ‘extreme but plausible’ is now wider than if exercises were done 18 months ago".

  3. Avoiding market disruption arising from commodity market volatility. As foreshadowed above, the FCA say they have a particular, additional focus on commodity trading firms due to recent periods of market volatility, having seen firms experience credit stress, higher trading costs and capital shortfalls as a result of episodes of market stress in energy, metals and government bond markets. They say they have also seen examples of ineffective governance contributing to firms’ failures to manage their resources effectively. The FCA have conducted enhanced monitoring and engagement with market participants given the risk that stressed market conditions could transmit to the wider financial system, and say they plan to do so going forward with PTFs specialising in commodity markets. Firms who provide clearing services as well as firms holding dominant market positions present a higher risk of harm in disorderly failure. The FCA will monitor PTFs' capital requirements in light of price movements and ensure they implement any additional regulatory requirements imposed on them to ensure their risk of harm to wider markets is managed.

  4. Operational resilience. The risk of disruption from technology outages and cyber-attacks is an ongoing challenge, as is cyber-enabled fraud. The potential for harm is increased by the complexity of the systems and processes supporting firms’ trading activities. The FCA say they expect firms that are in scope of the FCA's 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, but no later than 31 March 2025.They say they will review in-scope firms’ implementation plans in due course, and add that PTFs not formally in scope for those rules should nevertheless consider them as good practice.

  5. Brexit impacts. The FCA expect firms to inform them at the earliest opportunity if they are considering any changes as a result of Brexit, including to the movement of any staff, entity, trading desk or function. They are aware that a number of firms have implemented new structures for the execution and booking of transactions, and their risk management and oversight. These arrangements sometimes involve different entities operating across different jurisdictions and can add new complexity and additional risks. The FCA indicate that such arrangements, taken as a whole, must enable FCA-regulated firms to retain sufficient control and oversight of their regulated activities in the UK, so that they can be effectively supervised at all times.

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

These materials are for general information purposes only and are not intended to provide specific legal advice nor to be a comprehensive review of all developments in the law and practice, nor to cover all aspects of those referred to. Please take legal advice before applying anything contained in these materials to specific issues and transactions.