Does the deployment of algorithms combined with direct electronic access increase conduct risk? Evidence from the LME

Abstract

Purpose The purpose of this paper is to examine the effectiveness of two regulatory initiatives in developing awareness of conduct risk associated with algorithmic and direct-electronic access (DEA) trading at broker-dealers: the UK Financial Conduct Authority’s algorithmic trading compliance in the wholesale markets and Commission Delegated Regulation 2017/589 (CDR 589) to the second Markets in Financial Instruments Directive. Design/methodology/approach A qualitative examination of 15 semi-structured interviews with representatives of London Metal Exchange member firms, their clients and regulators. Findings This paper finds that the key conduct related messages in algorithmic trading compliance in the wholesale markets may not yet be fully embedded at broker–dealers. This is because of a perceived simplicity of the algorithms deployed by broker dealers or, alternatively, a lack of reflection on their impact. Conversely, a concern exists that clients’ deployment of algorithms on DEA channels provided by broker–dealers increase conduct risk. However, the threat of harm posed by clients is not envisaged in current definitions of conduct risk. Accordingly, CDR 2017/589 does not currently require firms to evaluate clients’ awareness of it. Research limitations/implications This study’s findings are limited to the insights provided by 15 participants. Originality/value This paper contributes to existing research by deepening understanding of conduct risk arising from algorithmic trading and DEA. To account for the potential harm arising from clients’ activities, this paper proposes a revision to Miles’s definition of conduct risk. This is complemented by a proposed amendment to CDR 2017/589 to require evaluation of clients’ understanding of conduct risk.

How effective are the enforcement activities of derivatives exchanges in the digital age? A survey of enforcement notices through the lens of humans

“…For some, this may Digital age be viewed as a manifestation of the conflict of interest that dissuades an exchange from disciplining certain types of exchange users, lest they decide to take their business elsewhere (Omarova, 2010;Bradley, 2000). Whether this has foundation or not, this is liable to frustrating member intermediaries who, despite their best efforts, cannot eliminate all the risks posed by their clients' trading (Culley, 2022). This may be seen as "lazy" enforcement by members.…”

Insights into UK investment firms’ efforts to comply with MiFID II RTS 6 that governs the conduct of algorithmic trading

“…As has been highlighted in earlier research into AT that seeks access to operational insiders, particularly, Culley (2022) and MacKenzie (2018), obtaining that access is challenging. This also applies if a researcher is seeking engagement from an extensive professional network, as in the author’s case.…”

“…This paper forms part of a broader project that seeks to examine the identification and mitigation of conduct risk in AT. The research design adopts that set out in Culley (2021). The interview protocol is included in the Appendix.…”

“…Be that as it may, there is a consensus among practitioners that AI-dominated markets are far from a reality. At the time of writing, rules-based algorithms continue to predominate in trading, with many machine learning models still relatively immature (2023b; Culley, 2022; Gozman et al , 2019).…”

“…Central to the aims of RTS 6 is the mitigation of conduct risk [4](Culley, 2020; Stangl, 2015). For example, Article 5 states that the prevention of disorderly conduct motivates the “behavioural testing” of order execution algorithms (Raschner, 2021).…”