FMSB Publishes Algo Risk Good Practice Standard
Posted by Colin Lambert. Last updated: April 22, 2024
The Financial Markets Standards Board (FMSB) has published its final Statement of Good Practice for the application of a model risk management framework to electronic trading algorithms, to support firms in applying model risk frameworks to the e-trading algorithms.
FMSB observes that the sophisticated modelling techniques used for calculating trading risk and required capital came under significant global regulatory scrutiny following the financial crisis as a result of their “acutely revealed shortcomings in containing risk”. It adds that regulatory guidance seeking to address the possible adverse consequences of decisions based on incorrect or misused models followed, applying to all model types including the use of models in algorithmic trading. “The degree of model risk and the potential magnitude of any adverse consequences varies significantly across model types,” it states, however.
The focus of the guidance is in areas where market practitioners, including “first line” risk owners and “second line” risk managers, have identified that the nature of model use in algos merits a differentiated approach compared with other model types.
The document lays out nine good practice statements, around model identification; the use of risk tiers; testing; validation; and model changes, with each having an associated commentary to help develop a robust risk framework. Examples looking at implementing such a risk framework are also provided.
“We would like to thank our members for this work addressing how to apply model risk management frameworks to electronic trading algorithms,” says Myles McGuinness, CEO of FMSB. “It is important that the industry comes together to make sure that good practice in a complex area such as this is set out in a way that can be well understood and easily applied, including practical examples.”
Ciara Quinlan, global head of principal electronic trading, FX, Rates and Credit at UBS, who led the Working Group, adds, “I am pleased that FMSB is able to publish the final Statement of Good Practice for the application of a model risk management framework to electronic trading algorithms. Harnessing expertise across the industry via FMSB to create guidance of this sort is immensely valuable and I hope what we have set out today will help to support all those across the industry working in this space, as well ultimately improving market effectiveness and confidence.”
The full paper can be found here.