What does MiFID currently do?
Are these provisions currently in MiFID?
What are the key differences between the current regime and MiFID2?
MiFID2 introduces a new regulatory regime for firms which engage in algorithmic and/or high-frequency trading (HFT). In consideration of the intention to subject all professional market participants to a license requirement, MiFID2 requires that even proprietary traders carrying out HFT in the EU apply for a license. Any firm carrying out algorithmic trading (including HFT) must notify the relevant competent authority and the relevant trading venue of its activity and is subject to numerous organisational requirements. Firms which pursue a market making strategy will be subject to quasi-market making obligations. A firm which engages in HFT will have to store order records and make them available to the relevant competent authority upon request.
In addition to the general requirements under MiFID2, firms carrying out algorithmic trading (including HFT) and trading venues allowing or enabling algorithmic trading will have to have in place specific effective systems, procedures and arrangements to ensure resilience and capacity, including testing and monitoring, as well as business continuity plans and mechanisms to control trading – including a “kill function”. Algorithms must also be flagged to allow identification of erroneous algorithms. Regulated markets must be prepared to interfere into the trading by slowing down the order flow and reducing the trading activity, by decreasing the number of unexecuted trades as well as requiring a minimum tick size. One means to achieve this constitutes of charging higher fees on firms operating a HFT technique.
What is MiFID2 going to do?
What does Level 1 say?
Directive 2014/65/EU Arts 4(1)(39) and (40); Arts 17(1) to 19(4)
‘algorithmic trading’ is defined as:
trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention, and does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions (Art 4(1)(39)).
‘high-frequency algorithmic trading technique’ is defined as an algorithmic trading technique characterised by:
(a) infrastructure intended to minimise network and other types of latencies, including at least one of the following facilities for algorithmic order entry: co-location, proximity hosting or high-speed direct electronic access
(b) system-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders, and
(c) high message intraday rates which constitute orders, quotes or cancellations (Art 4(1)(40)).
The new regime requires a firm which engages in algorithmic trading:
- To have in place effective systems and risk controls suitable to the business it operates to ensure that its trading systems are resilient and have sufficient capacity, are subject to appropriate thresholds and limits and prevent the sending of erroneous orders or the systems otherwise functioning in a way that may create or contribute to a disorderly market.
- To have in place effective systems and risk controls to ensure the trading system cannot be used for any purpose that is contrary to market abuse laws or to the rules of a trading venue to which it is connected.
- To have in place effective business continuity arrangements to deal with any failure of its trading systems.
- To ensure that its systems are fully tested and properly monitored.
- To notify its competent authority that it is engaging in algorithmic trading and of the trading venue at which the firm engages in algorithmic trading as a member or participant.
The relevant competent authority may require the firm that engages in algorithmic trading, on a regular or ad hoc basis to provide (without undue delay):
- a description of the nature of its algorithmic trading strategies
- details of the trading parameters or limits to which the system is subject
- the key compliance and risk controls the firm has in place to ensure the conditions in the points above are satisfied
- details of testing of its systems
A firm which engages in HFT shall store in approved form accurate and time sequenced records of all its placed orders, including cancellation of orders, executed orders and quotations on trading venues and shall make them available to its competent authority upon request.
A firm which engages in algorithmic trading to pursue a market making strategy shall, taking into account the liquidity, scale and nature of the specific market and the characteristics of the instruments traded:
- carry out this market making continuously during a specified portion of the trading venue’s trading hours, except under exceptional circumstances, with the result of providing liquidity on a regular and periodic basis to the trading venue
- enter into a binding written agreement with the trading venue which shall at least specify the obligations of the firm in accordance with the point above
- have in place effective systems and controls to ensure that it fulfils its obligations under that binding written agreement.
A firm which engages in algorithmic trading shall be considered to pursue a market making strategy when, as a member or participant of one or more trading venues, its strategy, when dealing on its own account, involves posting firm, simultaneous two-way quotes of comparable size and at competitive prices relating to one or more financial instruments on a single trading venue or across different trading venues, with the result of providing liquidity on a regular and frequent basis to the overall market.
A regulated market shall be required to have in place effective systems, procedures and arrangements, including requiring members or participants to carry out appropriate testing of algorithms and providing environments to facilitate such testing:
- to ensure that algorithmic trading systems cannot create or contribute to disorderly trading conditions on the market, and
- to manage any disorderly trading conditions which do arise from such algorithmic trading systems
Including systems to limit the ratio of unexecuted orders to transactions that may be entered into the system by a member or participant, to be able to slow down the flow of orders if there is a risk of its system capacity being reached and to limit and enforce the minimum tick size that may be executed on the market.
Member states may allow a regulated market to impose a higher fee on participants operating HFT technique in order to reflect the additional burden on system capacity.
A regulated market shall be required to be able to identify, by means of flagging from members or participants, orders generated by algorithmic trading, the different algorithms used for the creation of orders and the relevant persons initiating those orders.
What does Level 2 say?
Phase 1 (May 2014 to Aug 2014):
ESMA Consultation Paper CP 2014/549 (CP1) and Discussion Paper DP 2014/548 (DP)
- In relation to the definition of “high-frequency algorithmic trading”, ESMA in CP 1 advised the Commission to follow one of the following options as proxies for the identification of “high message intraday rates”:
- Option 1: Absolute threshold per instrument: a participant/member would be deemed to have a “high message intraday rate” when the average number of messages sent per trading day to any single liquid instrument traded on a venue is above 2 messages per second.
- Option 2: Absolute threshold per trading venue and per instrument: a participant/member submitting on average at least 4 messages per second with respect to all instruments across a venue or 2 messages per second traded with respect to any single instrument traded on a venue would be deemed to have a “high message intraday rate”.
- ESMA noted that the determination of the median daily lifetime of the orders submitted to the trading venue by all members should only be made for liquid instruments, and that only orders relating to instruments falling within the MiFIR definition of liquid should be considered in this context.
- ESMA also noted that once a firm is deemed a HFT in one market it should be considered as such for all trading venues in the EU.
In the DP, ESMA sets out the organisational requirements for firms that engage in algo-trading which include:
- Prior initial testing which includes performance simulations and back testing of algorithms, venue trading testing and conformance testing
- Pre-trade controls to ensure fair and orderly trading
- Pre-trade risk limits that are appropriate for a firms capital base, clearing arrangements, trading style and experience which must include as a minimum (i) price collars, (ii) maximum order value, (iii) maximum order volume, (iv) maximum long-short positions and long/short overall strategy positions, (v) automated execution throttles, (vii) kill buttons, (viii) outbound message rates and message limits, and where appropriate (iv) market maker protections
- Records for at least 5 years of their algorithmic trading systems and algorithms, which should be sufficiently detailed to enable authorities to monitor firms’ compliance, and
- Monitoring and alert systems that enable the firm to monitor trading behaviour of individuals and identify behaviour likely to raise suspicions of market abuse.
Phase 2 (Dec 2014 to March 2015):
Final Report 2014/1569 (FR) and Consultation Paper 2014/1570 (CP2)
In relation to the definition of “algorithmic trading”, ESMA in the FR has clarified the following:
- “where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, the price or quantity of the order or how to manage the order after its submission” means that automated trading decisions and the optimisation of order execution processes by automated means are included in the definition of algorithmic trading
- “with limited or no human intervention” means that arrangements are considered as algorithmic trading if the system makes independent decisions at any stage of the processes on either initiating, generating, routing or executing orders. It is noted that the reference to “orders” encompasses “quotes” as well
- “does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters” excludes automated order routers that only determine the venue(s) where the order should be submitted without changing any other parameters of the order.
- Many industry bodies strongly disagreed with both options presented by ESMA in CP1 arguing that both definitions did not take into account the complexities of modern firms which offer a wide variety of services. Simply because a firm pursued a HFT strategy in relation to part of its business should not characterize the entire firm as a HFT firm.
- Some bodies argued that the entire outcome would be disproportionate and would require regulators to examine framework, policies and procedures data which is completely unrelated to HFT.
- Additional concerns were raised that subsequent European or National legislation that may place additional requirements on HFT would refer back to an investment firm’s classification under MiFID2.
- Rather than provide greater clarification in the follow-up FR, ESMA has muddied the waters further by presenting a third option.
Option 3: Relative threshold: a member or participant in a trading venue would be deemed to have a “high message intraday rate” where the median daily lifetime of its modified or cancelled orders falls under a threshold below the median daily lifetime of all the modified or cancelled orders submitted to a given trading venue. If the Commission decides to follow this approach, ESMA recommends setting that threshold between the 40th and the 20th percentiles of the daily lifetime of modified or cancelled orders from all members or participants on a trading venue.
ESMA has accordingly left it up to the European Commission to decide which option to pursue though noted in its advice that a binary approach should be adopted in that if a firm is considered HFT firm then it should be subject to the requirements under MiFID2 regardless of the fact that HFT strategies are employed within only part of the firm.
ESMA also directed that any initial identification should remain focused on liquid instruments and only proprietary order flow should be considered. It follows that an investment firm classified as a HFT should be able to challenge its classification if it is a direct result of the firm’s non-proprietary messaging flow. To that end, investment firms should analyse the records under Article 25 of MiFIR to determine the level of messaging activity which is attributable to the proprietary activities of the investment firm, and the level which is attributable to the clients of the investment firm and provide this summary to the relevant competent authority who would determine whether the firm has been incorrectly identified as exhibiting a “high intraday message rate”.
The proposed RTS 13 in CP2 provides for the detailed requirements in relation to firms engaging in algorithmic trading in relation to:
- organisational requirements, including governance, role of compliance, staff policies, training and understanding of market abuse and IT outsourcing and placement
- resilience of trading systems, including testing of algorithms and systems - conformance, initial and prescribed annual stress testing, annual review (including 25 matters to be included as a minimum to ensure a “detailed and robust” self-assessment)
- real-time monitoring
- a “kill functionality” to be able to cancel all outstanding orders at all trading venues, embedded in both the firm’s own systems as well as those of the trading venue, and a separate capability to cancel orders at individual trading venues or originating from individual traders, trading desks or, where applicable, clients
- business continuity arrangements including duplication of hardware to permit continuous operation
- pre-trade controls on order entry and post-trade controls
- appropriate arrangements for physical and electronic security
RTS 14 in CP 2 which sets out organisational requirements of regulated markets, multilateral trading facilities and organised trading facilities applies to trading venues which allow for or enable algorithmic trading and addresses the risks arising from algorithmic trading. In particular, such trading venues shall require members to test their trading algorithms to avoid disorderly trading conditions, shall impose “throttle limits” and pre-and post-trade controls on members and have a manual “kill functionality” which, when activated, will disable the ability of a member or participant to trade and will cancel all resting orders of that firm.
RTS 15 in CP2 requires that firms engaged in algorithmic trading and intending to pursue a market making strategy shall communicate their intention to the venue. Firms engaged in algorithmic trading and pursuing a market making strategy shall sign a market making agreement following notification from the venue, failing which the venue shall disconnect the strategy identified. The draft RTS stipulates the minimum content requirement for such an agreement.
A trading venue shall ensure that its market making agreement specifies that in case of exceptional market circumstances, as defined in the draft RTS, the firm will not have to adhere to all the obligations as long as those exceptional circumstances remain.
The venue shall establish a market making scheme with respect to the firms which engage in algorithmic trading that pursue market making strategies in it. The scheme shall be fair and on-discriminatory and the terms shall be publicly disclosed on the venue’s website and any proposed changes shall be notified not less than three months before the proposed effective date of such changes.
Will any Member States be gold-plating?
- Algorithmic trading and HFT are subject to enhanced scrutiny by European regulators and it is likely we will see some Member States applying additional regulation at a national level in the future. To date, Germany has been the main jurisdiction which has led the way with the regulation of HFT.
- The German Federal Parliament adopted a bill in February 2013 setting forth detailed rules and provisions dealing with HFT. These rules came into force on 14 May 2013. Under the current regime in Germany dealing on one’s own account is now considered a financial service (and thus triggers a licensing requirement) if it is done using ‘high-frequency algorithmic trading techniques’, which are characterized by:
- The exploitation of infrastructures intended to minimize latency,
- A system automatically ‘deciding’ whether orders are submitted, generated, transmitted or executed without the necessity of human intervention for individual trades or orders, and a high intraday number of orders, quotes or cancellations.
- In addition to licensing requirements the German HFT rules impose additional organization requirements for certain firms that engage in HFT, a reporting regime and an order to trade ratio requirement.
When will it happen?
When will these provisions apply?
Member States are required to adopt and publish measures transposing MiFID2 and delegated acts into national law by 03 July 2016. MiFID2 and delegated acts under MiFID2 will apply from 03 January 2017.
What happens next?
ESMA delivered its final technical advice for delegated acts on the 19 December 2014 to the European Commission in the FR. The European Commission is working to adopt the delegated acts which is likely to happen in July or September 2015. The European Parliament and Council have the right to object to a delegated act within 3 months (which can be extended by a further 3 months). If they do not object, it is hoped that they will be published in the Official Journal in early 2016.
Deadline for responses to CP2 was 02 March 2015, following which ESMA has updated the draft technical standards (RTS and ITS) and published them on 30 June 2015. The European Commission has up to 3 months to endorse the RTS and ITS. The European Parliament and the Council will then have three months to object to the RTS and ITS. Again, if they do not object, it is hoped that they will be published in the Official Journal in early 2016.
How is it going to impact my business?
Who will be affected by these changes and how will it impact their business?
- Until the European Commission decides on the definitions of algorithmic trading and HFT the outcome for some firms remains unclear.
- If a firm is found to use techniques which fall within the definition of HFT, then even a person simply dealing on their own account using a HFT technique will fall within the scope of MiFID2 and will therefore have to be authorized as an investment firm.
- Firms caught by these new requirements will need to ensure they have systems and controls in place that satisfy the regulator that its trading systems meet numerous requirements, the highlights of which include:
- systems and risk controls
- notifications to the regulator
- disclosure of information to the regulator about algorithmic trading, such as a description of the nature of its algorithmic trading strategies, compliance and risk controls, and details of systems testing
- flagging of orders created by algorithms and record keeping, including time sequenced records of all placed orders, cancelled orders, executed orders and quotations on trading venues to be stored in an approved form, and
- obligation to carry out any market making continuously during a specified proportion of the trading venue’s trading hours to provide liquidity on a regular and predictable basis to the trading venue.
In addition, such firms will be required to subject their algorithms to stringent testing and keep detailed records of their trading for a period of 5 years.
Non-MiFID firms firms which employ algorithmic trading and/or HFT techniques on a regulated market/trading venue will be subject to the new mechanisms, processes and controls which such venues are required to implement under MiFID2, including on-site testing of algorithms to avoid disorderly trading conditions, capacity and monitoring obligations and trade controls (including pre-trade controls and “kill functionality”).
Action for firms?
- Consider implications of ESMA’s FR and CP2 published December 2014 an ongoing discussions within the industry in the lead up to the publication of final Level 2 measures.
- Consider the implications of the European Commission’s definition of algorithmic trading and HFT following the publication of the delegated acts and assess whether firm’s practices are caught by the new regime.
- Review current practices and procedures and analyse changes required and/or new systems required to meet the organizational and testing requirements for algorithmic trading and/or HFT.
- Implement organizational requirements to ensure compliance with record keeping, reporting and testing requirements.
- Prepare required internal documentation and/or amend existing documentation in line with new requirements.
- Implement staff/ personnel training to ensure they are aware of new organizational requirements and firms risk strategy and systems with regards to algorithmic trading and HFT.