MiFID II implications on algorithmic trading
Prepare yourselves… MiFID II is coming and will bring in its bag significant regulation changes which will impact, among other things, algorithmic trading businesses. So here is a foretaste of what is coming so you can start preparing for it. Do not worry… We’ll be here to help you in the process!
The final MiFID II texts have been published on the EU Official journal and entered into force 2nd of july 2014. However, they will only enter into application the 3rd of january 2017 which gives time to comply. The precise implementations measures which will define acts and technical standards are however not defined yet, but ESMA and FCA are working on it and we expect documents being available mid-2015.
Except if you spent the last 5 years in a nuclear bunker without connectivity to the outside world, you are certainly aware that high frequency trading and more generally, algorithmic trading, has been shining in the news up to the points it probably even brought the attention of your concierge… which is never a good sign in the markets! Bad press only really. Debate has been going on and on between HFT supporters and critics on poor and cons of high frequency trading. Supporters claiming greater liquidity, greater market efficiency, lowering of transaction costs from spread narrowing to better order execution, etc.
But the regulators have arbitrated otherwise! They tend to consider that algorithmic trading and more especially high frequency trading are at the root of some market distorsion and that their liquidity tend to disappear in the worst time, accelerating and amplifying the panic during crisis. They worry about the high rate of orders being cancelled, the overload on the systems, etc. So MiFID II brings among other things regulation and monitoring of algorithmic trading, algorithmic traders and venues, from regulated markets places to multilateral trading facilities (MTFs) and organised trading facilities (OTFs). We will focus here on the changes about algorithmic trading rather than on the one concerning the execution venues.
First question to solve for the regulators. How do we define algorithmic trading, or more precisely here, what activities fall as being algorithmic trading?
In a few words, it is the use of computer algorithms to decide whether entering or not an order and when, to decide the parameters of the orders and how to manage it once executed. The whole process without (or with limited) human interaction. It is interesting to note that systems used to route orders to venues, to confirm execution or any post-trade event systems are out of scope. Systems which have no effect on the trading parameters are logically out of scope.
This will consequently include both sell side (such as brokerage proposing execution algorithms) and buy side (such as investment firms running systematic automated strategies). These firms will have to (article 17):
– 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.
– have appropriate trading thresholds and limits which prevent sending erroneous orders.
– make sure the systems not function in a way that may create or contribute to a disorderly market and cannot be used for any purpose that is contrary to the rules of a trading venue to which it is connected.
– have effective business continuity arrangements to deal with any system failure of its trading systems.
– ensure their systems are fully tested and properly monitored to meet the above requirements.
Hopefully, any serious actor in the algorithmic trading industry already took in consideration these obligations of common sense when building their trading systems. The anxiety is more about the associated compliance and orgasitional cost which could build a serious barrier to entry… The organisational obligations will be specified later. However it is important to note that we already know that they will be adapted depending the type of firm. To quote the directive: “Those principles and standards should apply taking into account the nature, scale and complexity of investment firms.” Giving hope that the regulatory and compliance costs will be adapted to the nature of the firm and the business it conducts.
The market places will also have new obligations such as:
– requiring members or participants to carry out appropriate testing of algorithms and providing environments to facilitate such testing.
– ensuring that algorithmic trading systems cannot create or contribute to disorderly trading.
– managing 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.
– being able to slow down the flow of orders if there is a risk of its system capacity being reached.
– limitating and enforcing the minimum tick size that may be executed on the market
High Frequency Trading
High Frequency trading is a subset of algorithmic trading, particularly pointed as responsible of many recent market disorders. So they fall of course in scope of the new obligations described above. But they will have extra…
Once again, first it is necessary to define, regulatory speaking, who fall in the high frequency trading bucket.
To quote the ESMA directive:
A specific subset of algorithmic trading is high-frequency algorithmic trading where a trading system analyses data or signals from the market at high speed and then sends or updates large numbers of orders within a very short time period in response to that analysis.
In particular, high-frequency algorithmic trading may contain elements such as order initiation, generating, routing and execution which are determined by the system without human intervention for each individual trade or order, short time-frame for establishing and liquidating positions, high daily portfolio turnover, high order-to-trade ratio intraday and ending the trading day at or close to a flat position.
High-frequency algorithmic trading is characterised, among others, by high message intra-day rates which constitute orders, quotes or cancellations.
In determining what constitutes high message intra-day rates, the identity of the client ultimately behind the activity, the length of the observation period, the comparison with the overall market activity during that period and the relative concentration or fragmentation of activity should be taken into account. High-frequency algorithmic trading is typically done by the traders using their own capital to trade and rather than being a strategy in itself is usually the use of sophisticated technology to implement more traditional trading strategies such as market making or arbitrage.
To identify these firms, two options are proposed. The first one following the one currently used by the German regulators with defined thresholds such as message rates. The second option is more opened and propose to identify firms which their trade median lifestime on a venue is well lower than the average on the venue. If a firm is considered as being an HFT in a venue, it will automatically be considered as HFT on all venues.
So now let’s see what is coming for them. An investment firm that engages in a high-frequency algorithmic trading technique will have to store, for at least five years, in an approved form accurate and time sequenced records of all its placed orders, including cancellations of orders, executed orders and quotations on trading venues and shall make them available to the competent authority upon request.
On the exchange side, venues will have to guarantee a “fair” access to co-location, proximity hosting or high speed direct electronic access, or globally any tools or services important to high-frequency traders.
Regarding market-making activities, the main concern of the regulators is to prevent behaviours which may worsen or lead to events such as the May 2010 Flash Crash. The criticism to market-makers is that they tend to withdraw themselves (and so their liquidity) in the worse time, meaning in period of high volatility.
The usual problem is now to be able to define who fall in scope of the market-making category. According to the directive:
An investment firm that engages in algorithmic trading shall be considered to be pursuing a market making strategy when, as a member or participant of one or more trading venues, its strategy, when dealing on 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
It is interesting to see that the definition is quite precise and seems to exclude quoting the two legs in similar instruments but different venues…
So the ESMA directive asks to the firms who will engage in market-making activities, in addition of the classical algorithmic trading obligations, to:
– carry out this market making continuously during a specified proportion of the trading venue’s trading hours, except under exceptional circumstances (still to be defined!), with the result of providing liquidity on a regular and predictable basis to the trading venue.
– enter into a binding written agreement with the trading venue which shall at least specify the obligations of the investment firm in accordance with the above point.
– have in place effective systems and controls to ensure that it fulfils its obligations under the above agreement.
On the other side, the trading venues will have to :
– write agreements with all investment firms pursuing a market making strategy on the regulated market.
– ensure that a sufficient number of investment firms participate in such agreements which require them to post firm quotes at competitive prices with the result of providing liquidity to the market on a regular and predictable basis.
It seems that these minimum obligation thresholds (such as a minimum presence of 80-90% of trading hours, maximum spread, minimum quotation size, etc) will not be set in absolute as part of the MiFID II texts and will be more left to the venues to decide.
First… stay positive! Any market structural change bring new opportunities to the ones looking forward…
Alpha Novae is going to follow very precisely what is coming next (in term of algorithmic trading, high-frequency trading and market-making trading obligations), in order to comply its systems (such as AlphaTrader) to MiFID II, if it is not already the case, and help you to make the transition as seamless as possible. Do not hesitate to contact-us if you have any questions.