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Real-Time Risk Management: A View on MiFID II Compliance Challenges

The flip-side of changing market structures, furtherance of technologies and evolution of investment services is the emergence of risks hitherto unknown. Regulatory response to these challenges translates into swift and expansive reforms to curb and mitigate systemic risks and to maintain market order.  While these reforms will have an extensive impact on a variety of stakeholders, a corollary for the financial institutions will be the way risk is identified, controlled and mitigated as a continuous process

MiFID II reforms tackles this cycle of innovation challenges — reform initiatives — risk strategy adjustments through a system of limits, qualitative and quantitative controls and persistent surveillance mechanisms.

1. Risk Mitigation through Limits & Controls

The two dominant and time-tested strategies in risk mitigation are limits management and control mechanisms. The regulators under MiFID II reforms too adopted these to promote financial stability and coherent markets. Managing risk through limits has two vital benefits:

  •  Setting thresholds of tolerance ensures that the organisation is consciously acknowledging the risk appetite and,
  •  Monitoring of these thresholds on a real-time basis ensures that the organisation is well within the boundaries of the organisational and regulatory risk limits

While limits tend to be quantitative in nature, controls assume qualitative approach in managing risk effectively. The MiFID II regulatory reforms provide for managing risk through limits and control via a number of Level 1 (Recitals and Articles) and Level 2 (RTS/ITS) measures.

1.1 Algorithmic Trading

The advancements in technology over the past decade led to the introduction of Algorithmic/High-Frequency Trading (HFT). While the use of HFT methodology is associated with increased liquidity, decreased short-term volatility and narrow spreads, it is also viewed as an agent of disruption to the overall fair and seamless functioning of the market if not used in a controlled manner. The regulatory stress is on the controlled deployment of algorithms by setting cautious limits. The limits apply to a number of factors such as Number of financial instruments being traded, Price & value of the instruments, number & Value of the orders,Strategy positions, etc.

Apart from the quantitative limits, there are various qualitative controls to be implemented by the organisation under MiFID II. RTS 6 of directive elaborates on various topics of the qualitative controls that firms need to put in place while using Algorithmic trading techniques including Implementation Governance, Organisational Governance, Controls on Deployment & Usage and  On-going Compliance

1.2 Trade Controls

Since the trading firms are subjected to different kinds of risk, the directive accommodates different kinds of controls to address and manage such risks. Pre and Post-trade risk controls have to be put in place to discourage unruly trading and to monitor credit/market risk respectively.  

The pre-trade controls include Controls on Order entry, Trade Strategy Application and Trade Eligibility while the Post-Trade Controls are for managing Credit and Market Risk, Trade Reconciliation, Specific Product Types and Governance.

1.3 Real-Time Monitoring & Alerts

All the controls mentioned in relation to algo-trading, pre and post-trading are subjected to real-time monitoring. This should cover trading activity including those on behalf of clients and should check for signs of disorderly trading.

These real-time alerts must be capable of notifying the appropriate staff and control authorities any breaches in the threshold limits set. The RTS defines real-time alerts as those generated within 5 seconds of the relevant event.

2. Risk Monitoring through Surveillance

Another crucial area in risk management and control is with respect to Surveillance. An essential cog in risk monitoring, surveillance assumes various forms, more so with current advancements in technology. While MiFID I introduced surveillance mechanisms for equity traders, the rapid evolution of communication systems and the resultant adoption across financial systems only meant that it needed reinforcement. 

Evidently, there are two fundamental sides to surveillance and monitoring under MiFID II:

  •  To record all forms of communication and data —tagged and timestamped and,
  •  To store and retrieve it on demand — regulatory or otherwise

2.1 The WHAT TO

  •  Communication Monitoring: Recording and monitoring of all types of trade communication across asset classes whether it takes the form of email, instant messengers, voice or even face-to-face meetings.
  • Trade Data Recording: Recording and storage of trade data, though is a practice which is existing in many organisations already, firms could take this opportunity to relook at the trade data warehouse strategies to ensure that the data supports strategic and regulatory requirements. 
  • Market Data: Having trade data without all the supplementary market data that went into the trading decision/strategy will result in an incomplete jigsaw. It is essential for the organisations to record and store market data including benchmark indices referenced. Utilising the power of trade analytics for pre and post-trade analysis also requires this.

 2.2 The HOW TO

  • Safety: Storing the data in a safe manner minimising the possibilities of data corruption for a minimum of 5-7 years
  • Retrievability: Storing the data in a manner which is easily and entirely retrievable, whether on-demand or periodically
  • Business Continuity: Inclusion of Surveillance data in Business continuity plans for minimising the risk of data loss through necessary backups and other mechanisms
  • Adequacy: Anticipating and ensuring that adequate physical space and storage capacity is available to meet the growing needs of storing surveillance data
  • Unified: Ability to unify the surveillance and recording requirements across the bank (business lines, desks, regions, etc.)

Concluding Thoughts

MiFID II compliance timeline of 2018, is not far from where we stand today. Given that the regulatory scenario is buzzing with activity across the strata of financial industry, vying for the same set of resources and overlapping timelines, it is a challenging period for financial institutions. 

Since this landmark regulation has a multi-asset and multi-functional impact, financial firms should not only view this as a compliance exercise rather as an opportunity to upgrade and overhaul systems, processes and governance structures. While organisations need to relook at strategies, mobilise resources and make swift decisions in implementing in-house or third-party solutions where possible, they should also focus on building and investing in flexible and robust systems which can accommodate future regulatory or strategic objectives. This balance will prove to be a critical success factor in the long-term for financial institutions.


Disclaimer: The views and opinions expressed herein are those of the author and do not represent the views and opinions of the Associates in Capital Markets (ACAPM) or any of its subsidiaries or affiliates or clients.


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