There is no doubt that the current financial environment is strongly technology dependent which in turn has given rise to trading incredible volumes at very low costs. Information Technology has given the capability to investors to make informed decisions and invest in financial instruments nearly worldwide at the click of a button having even Direct Market Access, from home, real time and henceforth track the performance of their investments. Understanding the complexity of this networked environment of regulated companies that link up to enable them to offer these services to their clients is important because it highlights the responsibilities of each of the players and EU regulation currently applied to ensure best execution as well as investor protection.

An order to e.g. buy a certain financial instrument would flow between at least 3 entities, the Investment Firm that receives and transmits the order, the Trading Platform or Stock Exchange that executes the order and the Bank that settles the order and acts as a custodian to the assets. ESMA, the EU supervisory authority, has issued guidelines on systems and controls that these Investment Firms should employ and these have been adopted by the Member State’s regulatory authorities, in Cyprus being the Securities and Exchange Commission.

To this effect, the following article explains the systems and controls that are mandatory to regulated investment firms and the investor protection provided, including best execution. These are required by Trading Platforms providing execution as well as Investment Firms (including Investment Firms allowing Direct Market Access to their clients) providing reception and transmission of orders. The guidelines, in a nutshell, are:

1. Suitability of the Trading Systems. The procurement of electronic trading systems (ETS) should be governed by a formal process in selecting the most suitable system that is fit for purpose. This system has to embed compliance and risk management principles and once installed and customised should go through a formal test programme based on functionality test scripts per module, per system and per holistic user level. Such a system should have the capacity and resilience to handle peaks and also have a Disaster Recovery plan in place with the aim of avoiding disruption of the service to investors.

Additionally, once in production, the ETS should be monitored and reviewed continuously by knowledgeable and trained staff, both in technology and company policies that can spot market abuse that could be detrimental to investors. These personnel must be directly reachable by the member state SEC and possess appropriate authorisation to take immediate action, if required. Furthermore, record keeping is mandatory to the extent of reconstructing transactions as well as documenting major incidents and associated risks.

2. Fair and orderly trading. Reception, transmission and execution of orders should be based on best execution policies implementing fair and orderly trading. For example, similar price and size orders should be executed sequentially, securing thus the integrity of the financial markets. The Investment Firm should perform adequate due diligence for its customer’s transactions and monitoring. Users of the order entry book should be adequately trained to access it and pre and post trading controls should be in place. The ETS should be able to limit the access and allow intervention on transactions, prevent excessive flooding of order entry book and be able to constrain or even halt trading.

3. Preventing market abuse. Market abuse comprises of insider dealing and market manipulation. The ETS should employ specific technology to identify such market abuse practices. There are 4 main such abuses identified in the past that now all ETS are required to identify, namely,
   1. Ping orders, entering small orders to ascertain the level of hidden orders, particularly used to assess what is resting on a platform.
   2. Quote staffing, entering a large number of orders and/or cancellations/updates to orders so as to create uncertainly for other participants, slowing down their process and to camouflage their own strategy.
   3. Momentum ignition, entry of orders, or a series of orders, intended to start or exacerbate a trend, and to encourage other participants to accelerate or extend the trend in order to create an opportunity to unwind/open a position at a favourable price.
   4. Layering and spoofing, submitting multiple orders often away from the touch on one side of the order book, with the intention of executing a trade on the other side of the trade book. Once that has taken place, the manipulative orders are removed.

Not only ETS proactively disallows such abusive orders to be placed within the order book of the Trading Platform, but also knowledgeable staff must review the systems and when identifying such events report them directly to the appropriate regulatory body.

4. Direct market access. For Trading Platforms and Investment Firms providing Direct Market Access to their clients, they also assume the responsibility of trades of their clients.  Trading platforms and their members need to retain control of, and monitor, their systems to minimise any potential disruption caused by third parties to avoid trading platforms that are vulnerable to either potential misconduct or market abuse of DMA/SA clients or to their inadequate or erroneous systems. These include sophisticated investors that use trading software to access the order book or retrieve other information such as depth or volume of the order book.

Such Investment Firms offering DMA/SA should have the capability to perform due diligence to clients that they provide such a service and be able to intervene at any time to suspend, withdraw a Sponsored Access or stop an individual’s order. Additionally, trading platforms should have the capability to stop orders trading through a sponsored access separately from the orders of the member sponsoring that person’s access.

Again record keeping details enough to reconstruct a transaction is mandatory at all steps for compliance and reporting to SEC.

Concluding, EU ESMA guidelines require all the players in the execution of a customer order to employ such systems and controls to make sure that the investor interests are well protected.  At the same time, the integrity and smooth functioning of the financial market is ensured which are prerequisites for economic growth and wealth.