REGULATING HFT? HOW EUROPE IS DEALING WITH HFT
The issue of high frequency trading (“HFT”) has been the subject of increased attention from regulators across the globe. From Germany to other countries reacting recently with stricter regulation of HFT, the subject of regulating HFT while maintaining market efficiency and market integrity has been animating the media and pressuring regulators. In this context, MiFID II has introduced new provisions applying to HFT as a type of algorithmic trading.
Pressured in part by the controversy surrounding recent ‘flash crashes’, regulators are facing the challenge of maintaining the integrity of markets while not infringing on advances in the development of markets. In the United States, the Commodities and Futures Trading Commission (“CFTC”) is considering possible definitions of high frequency trading. In Europe, the European Commission proposals relating to MIFID II introduce trading controls for algorithmic trading activities.
On 15 April 2014, the European Parliament adopted the revised versions of the Markets in Financial Instruments Directive (“MiFID II”) and the new Markets in Financial Instruments Regulation (“MiFIR”). MIFID II will have a significant impact on how financial institutions conduct business in the 28 EU member states. The changes are designed to lower systemic risk and price manipulation while addressing loopholes in the current legislation under MiFID I.
On 22 May 2014, the European Securities and Markets Authority (“ESMA”) launched a consultation for the implementation of MiFID II and MiFIR as part of the process of translating requirements into applicable rules and regulations. ESMA published a Discussion Paper on MiFID/MiFIR draft RTS/ITS and a Consultation Paper on MiFID/ MiFIR on Technical Advice. In this extensive consultation, ESMA discusses market- related details pertaining to HFT as well as HFT-related definitions.
What is considered HFT in Europe?
MiFID II defines “Algorithmic trading” as trading in financial instruments where a computer algorithm automatically determines individual parameters of orders, such as whether to initiate the order, the timing of the order, price or quantity of the order or how to manage the order after its submission, all with limited or no human intervention. This definition does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the confirmation of orders.
MiFID II also states that a specific subset of algorithmic trading is high frequency 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. High frequency trading is typically done by traders using their own capital to trade, and rather than being a strategy in itself, it is most commonly the use of sophisticated technology to implement traditional trading strategies such as market making or arbitrage. A firm engaging in this would require effective monitoring systems and controls in place, such as “circuit breakers”, that stop the trading process if price volatility exceeds acceptable limits.
The provisions introduced by MiFID II include not only requirements for algorithmic traders to be properly regulated but also the requirement to provide liquidity when pursuing a market-making strategy. Firms which provide direct electronic access to a trading venue will also need to have in place systems and risk controls to prevent trading that may contribute to a disorderly market or involve market abuse.
More specifically, MiFID II addresses automated trading, including HFT by imposing the following requirements on firms:
- They will need to have systems and risk controls in place to ensure trading systems are resilient, have sufficient capacity, and prevent the sending of erroneous orders.
- They will need to have prescribed measures in place to ensure that their trading systems do not contravene the Regulation on Market Abuse.
- They will need to keep adequate records so that it can be provided to the regulator on request.
- Firms engaged in market-making will need to carry their market-making activities out continuously during a specified period of a trading venue’s trading hours to provide liquidity on a regular and predictable basis to the trading venues.
MiFID II requires ESMA to develop technical standards to implement rules on HFT. Those measures will complement actions taken by ESMA. Both ESMA and IOSCO have consulted on guidelines around the issue of HFT.
More specifically, in February 2012, ESMA published Guidelines on systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities. The guidelines require firms to test and monitor algorithms, and to have procedures in place to minimize the risk that their automated trading activity might give rise to market abuse. The algorithms will have to be tested on venues and authorised by regulators. Records of all placed orders and cancellations of orders will have to be stored and made available to the competent authority upon request.
ESMA has identified a number of ways that automated trading can be used to manipulate markets. It is concerned that market participants may use ‘ping orders’, quote stuffing, layering and spoofing, entering manipulative orders that are not executed and momentum ignition. The Market Abuse Directive applies to a majority of these behaviours. However, the proposed Market Abuse Directive (“MAD II”) introduces a much clearer link between HFT and a number of abusive practices that have been regulated previously by MAD.
MiFID II requires ESMA to develop technical standards to implement rules on HFT. ESMA will continue consulting with the industry while developing those technical standards.
The lack of consensus amongst regulators on a global scale means that HFT firms must keep up-to-date on requirements in all jurisdictions, while dealing with compliance and reporting issues one country at time. The challenge for regulators will be to keep pace with innovative financial markets.
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EBA FINAL DRAFT TECHNICAL STANDARDS AND GUIDELINES ON METHODOLOGY AND DISCLOSURE FOR G-SIIS
On 5 June 2014, the European Banking Authority (“EBA”) published final draft regulatory technical standards (“RTS”), implementing technical standards (“ITS”) and guidelines relating to the requirements in the CRD IV Directive (2013/36/EU) (“CRD IV”) and the Capital Requirements Regulation (Regulation 575/2013) (“CRR”) on global systemically important institutions (“G-SIIs”). CRD IV requires G-SIIs, among other things, to hold higher capital levels to contain the risks they pose to the financial system and the impact that their potential failure may have on sovereign finance and taxpayers.
The EBA consulted on the draft technical standards and guidelines in December 2013. The below documents contain details of the feedback that the EBA received during the consultation process.
The EBA published the following:
- Final draft RTS on the methodology for identifying G-Slls (EBA/RTS/2014/07);
- Final draft ITS on special disclosure rules applicable to G-SIIs (EBA/ITS/2014/03); and
- Final guidelines on special disclosure rules for large institutions (EBA/GL/2014/02).
Identification of G-Slls
The final draft RTS provide consistent parameters and specify a harmonised methodology for identifying G-SIIs across the EU for determining their adequate levels of capital. According to CRD IV, competent authorities in each member state shall calculate, on an annual basis, an individual score to measure a bank’s systemic significance. To this end, CRD IV defines five categories of indicators to be used in this scoring process. The final draft RTS specify twelve quantifiable indicators falling under these five categories, which ultimately measure the impact that the failure of an institution may have on the stability of the global financial system. The EBA will support competent authorities in carrying out the identification process to ensure practicability and convergence.
The identification of G-SIIs in the EU is aligned with the framework established by the Financial Stability Board and developed by the Basel Committee on Banking Supervision (“BCBS”). These standards and guidelines will be part of the EU single rulebook in banking and aim to enhance regulatory harmonisation and disclosure across the EU.
An accompanying press release dated 5 June 2014 states that identification as a G-SII, which leads to a higher capital requirement, will take place in January 2015 for the first time. The higher capital requirement will apply one year after the publication, by competent authorities in each member state, of banks’ scoring results. This is to allow institutions enough time to adjust to the new buffer requirement.
The final draft ITS define uniform requirements for disclosing the values used during the identification and scoring process of G-SIIs. Uniform and enhanced disclosure will ensure fair competitive conditions between comparable groups of institutions, thus resulting in greater convergence of supervisory practices and more accurate risk assessments across the EU. Furthermore, uniform disclosure aims at improving data quality and strengthening market discipline. This level of disclosure goes even beyond the minimum standards required by the BCBS.
Finally, in order to increase transparency in the identification process, the final guidelines on special disclosure stipulate that not only G-SIIs, but also other large institutions with an overall exposure of more than EUR 200 billion and which are potentially systemically relevant, will be subject to the same disclosure requirement as the G-SIIs. The EBA will act as a central data hub in this disclosure process, thus providing a platform to aggregate data across the whole EU.
EIGHT DELEGATED REGULATIONS ON CRD IV FRAMEWORK PUBLISHED IN THE OFFICIAL JOURNAL OF THE EU
On 20 May 2014, three delegated Regulations which supplement the CRD IV Directive (2013/36/EU) with regard to certain regulatory technical standards, have been published in the Official Journal of the European Union (“OJ”). They are:
- Commission Delegated Regulation (EU) No 524/2014 of 12 March 2014 supplementing Directive 2013/36/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the information that competent authorities of home and host Member States supply to one another;
- Commission Delegated Regulation (EU) No 527/2014 of 12 March 2014 supplementing Directive (EU) No 2013/36/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the classes of instruments that adequately reflect the credit quality of an institution as a going concern and are appropriate to be used for the purposes of variable remuneration; and
- Commission Delegated Regulation (EU) No 530/2014 of 12 March 2014 supplementing Directive 2013/36/EU of the European Parliament and of the Council with regard to regulatory technical standards further defining material exposures and thresholds for internal approaches to specific risk in the trading book.
On the same day, the following five European Commission delegated Regulations supplementing the Capital Requirements Regulation (Regulation 575/2013) (“CRR”) with regard to certain regulatory technical standards were published in the OJ:
- Commission Delegated Regulation (EU) No 523/2014 of 12 March 2014 supplementing Regulation (EU) No 575/2013 of the European Parliament and of the Council with regard to regulatory technical standards for determining what constitutes the close correspondence between the value of an institution’s covered bonds and the value of the institution’s assets;
- Commission Delegated Regulation (EU) No 525/2014 of 12 March 2014 supplementing Regulation (EU) No 575/2013 of the European Parliament and of the Council with regard to regulatory technical standards for the definition of market;
- Commission Delegated Regulation (EU) No 526/2014 of 12 March 2014 supplementing Regulation (EU) No 575/2013 of the European Parliament and of the Council with regard to regulatory technical standards for determining proxy spread and limited smaller portfolios for credit valuation adjustment risk;
- Commission Delegated Regulation (EU) No 528/2014 of 12 March 2014 supplementing Regulation (EU) No 575/2013 of the European Parliament and of the Council with regard to regulatory technical standards for non-delta risk of options in the standardised market risk approach; and
- Commission Delegated Regulation (EU) No 529/2014 of 12 March 2014 supplementing Regulation (EU) No 575/2013 of the European Parliament and of the Council with regard to regulatory technical standards for assessing the materiality of extensions and changes of the internal ratings based approach and the advanced measurement approach.
The European Commission adopted all the delegated Regulations on 12 March 2014 which will come into force twenty days after their publication in the OJ.
EBA LIST OF COMMON EQUITY TIER 1 CAPITAL STANDARDS
On 28 May 2014, the European Banking Authority (“EBA”) published a list of capital instruments issued by institutions across the EU that have been classified by national competent authorities (“NCAs”) as common equity tier 1 (“CET1”) capital under Article 26(3) of the Capital Requirements Regulation (Regulation 575/2013) (“CRR”).
An accompanying EBA press release states that the list has been put together on the basis of information received as of 28 June 2013, to give a clear cut reference date for CET1 capital instruments issued before the entry into force of the CRR on 1 January 2014. The information provided in the list is consistent with the information to be reported according to the implementing technical standards on disclosure for own funds. Among other things, the list includes information on:
- The name and governing law of the CET1 capital instrument in English and in the relevant national language;
- Whether the CET1 capital instrument can be issued in addition to other CET1 capital instruments;
- Whether there are voting or non-voting rights;
- Whether the CET1 capital instrument is a grandfathered state aid or non-state aid instrument; and
- Whether the CET1 capital instrument is fully eligible under Article 28 or 29 of the CRR.
This is the first time an exhaustive overview of CET1 capital instruments available in member states has been published. The list will be updated on a regular basis, in line with the EBA’s mandate to constantly review and monitor the quality of own funds instruments issued by institutions across the EU.
EBA LAUNCHES CONSULTATION ON SUPERVISORY BENCHMARKING OF INTERNAL APPROACHES AND FOR CALCULATING CAPITAL REQUIREMENTS
On 28 May 2014, the European Banking Authority (“EBA”) published a consultation (EBA/CP/2014/07) on draft implementing technical standards (“Draft ITS”) and regulatory technical standards (“Draft RTS”) intended to specify the EU framework for the conduct of annual supervisory benchmarking of internal approaches for calculating own funds requirements for credit and market risk exposures (“RWAs”) under Article 78 of the CRD IV Directive (2013/36/EU). There are nine accompanying annexes to the consultation, links to which are provided in an EBA press release which announced the publication of the consultation.
The Draft ITS, the text of which are set out in chapter 4(b) of the consultation, provide:
- A set of benchmark portfolios for credit and market risk, based on recent EBA experiences.
- Templates, definitions and IT solutions that firms will be asked to use when reporting the results of their calculations of capital requirements.
The Draft RTS, the text of which are set out in chapter 4(a) of the consultation, define:
- The common general benchmarks for credit and market portfolios to be used by national competent authorities (“NCAs”) in the assessment of the quality of the internal approaches. The aim of these benchmarks is to identify significant differences in RWAs, together with significant and systematic underestimation of capital requirements.
- The procedures for sharing the results of the assessment of internal approaches carried out by each NCA with both the EBA and the other relevant NCAs.
The consultation closes to responses on 19 August 2014. Once the consultation has closed, the EBA will publish the responses received. The EBA has requested, and the European Commission has agreed to, a postponement of the deadline for the submission of the final draft ITS and RTS from 31 December 2013 to 30 September 2014. This is in view of the importance of implementing a robust benchmarking framework.
Publication of the consultation follows the EBA’s work on the comparability of capital requirements for the internal ratings-based approach for credit risk and market internal risk models, including carrying out a series of benchmarking exercises in 2013. This work has led to a better understanding of the causes of differences observed in RWAs across EU institutions. In the fourth quarter of 2014, the EBA intends to carry out another benchmarking exercise for credit and market risk, prior to adoption of the final draft ITS and RTS by the European Commission.
INTERGOVERNMENTAL AGREEMENT FOR THE SINGLE RESOLUTION FUND SIGNED
On 21 May 2014, the Council of the EU announced in a press release that 26 member states (i.e. all member states except the UK and Sweden) signed the intergovernmental agreement on the transfer and mutualisation of contributions to the single resolution fund (“IGA”) (8457/15) that will be established as part of the European banking union.
Under the IGA, contributions by banks raised at national level will be transferred to the single resolution fund (“SRF”), which will be built up over eight years, reaching a target level of at least 1% of the amount of covered deposits of all credit institutions authorised in all participating member states. It is estimated that this will amount to about £55 billion. The contributions will be gradually merged over the eight-year transitional phase. This mutualisation of paid-in funds will be front-loaded, starting with 40% in the first year, and a further 20% in the second year. The percentage will continuously increase by equal amounts over the subsequent six years until the SRF is fully mutualised.
The IGA will enter into force on the first day of the second month following the date when instruments of ratification, approval or acceptance have been deposited by signatories participating in the banking union that represent at least 90% of the aggregate of the weighted votes of all participants according to article 11(2) of the IGA. Member states that have signed the IGA, but are not yet part of the banking union (i.e. non-euro area member states) will only be subject to the IGA’s rights and obligations once they become part of the banking union.
In a declaration accompanying the IGA, the contracting parties commit to being bound by bail-in rules and principles, as outlined in the Bank Recovery and Resolution Directive. This will be a pre-condition for accessing the SRF.
In a press release welcoming the signing of the IGA, the European Commission invites all signatories to complete ratification of the IGA according to their national procedures before 1 January 2016. It advises that, in coming months, the European Commission will adopt a proposal for the Council of the EU implementing act on banks’ contributions to the SRF, which will specify the calculation methodology of the contributions. The European Commission also states that the transfer of banks’ contributions to the SRF will start from 1 January 2016.
The SRF is part of the single resolution mechanism (“SRM”). The purpose of the SRM is to ensure an orderly resolution of failing banks with minimal costs for taxpayers and to the real economy. The SRM Regulation is awaiting adoption by the Council of the EU following its adoption by the European Parliament in April 2014.
OMNIBUS II DIRECTIVE PUBLISHED IN THE OFFICIAL JOURNAL OF THE EU
The Omnibus Directive II (“Omnibus II”) (2014/51/EU), which, among other things, will amend the Prospectus Directive (2003/71/EC) in respect of the powers of the European Securities and Markets Authority (“ESMA”), has been published in the Official Journal of the EU on 22 May 2014.
Omnibus II is designed to amend the Solvency II Directive (2009/138/EU) to reflect the revised EU financial services supervisory framework known as the European System of Financial Supervision (“ESFS”) and align it with the legislative process introduced by the Lisbon Treaty including the new process for adopting level 2 measures.
Omnibus II will enter into force on 23 May 2014 being the day after publication in the Official Journal of the EU in accordance with article 8. It must be transposed into national law by 31 March 2015 and applied from 1 January 2016.
MAD II PUBLISHED IN THE OFFICIAL JOURNAL OF THE EU
On 12 June 2014, the text of the Market Abuse Regulation (Regulation 596/2014) (“MAR”) and the text of the Directive on criminal sanctions for insider dealing and market manipulation (2014/57/EU) (“MAD”) (together, “MAD II”) were published in the Official Journal of the EU. The MAD II framework aims to create an updated and strengthened market abuse regulatory framework with tougher and greater harmonisation of sanctions, including criminal sanctions.
The Council of the EU adopted MAD II on 14 April 2014. The European Parliament adopted MAR at first reading on 10 September 2013 and MAD on 4 February 2014. MAR expands and develops the existing EU market abuse regime and is designed to fit with the revision of Markets in Financial Instruments Directive (2004/39/EC) (“MiFID”). The European Commission is ultimately seeking to introduce a single European rulebook in the area of market abuse through MAR.
MAD II will enter into force 20 days after publication in the Official Journal of the EU. MAR will come into effect on 3 July 2016, with the exception of certain provisions specified in Article 39(2), which will apply from 2 July 2014. Member states have until 3 July 2016 to transpose MAD into their national law.
BANKING RECOVERY AND RESOLUTION DIRECTIVE PUBLISHED IN THE OFFICIAL JOURNAL OF THE EU
On 12 June 2014, the text of the Bank Recovery and Resolution Directive (2014/59/EU) (“BRRD”) was published in the Official Journal of the EU. The aim of the BRRD is to equip national authorities with harmonised tools and powers to tackle crises at banks and certain investment firms at the earliest possible moment, and to minimise costs for taxpayers. These tools and powers include preparatory and preventative measures (i.e. requiring firms to prepare recovery plans), early supervisory invention powers and resolution powers given to the resolution authorities to ensure the continuity of essential services and to manage failure of a firm in an orderly way.
The BRRD will also establish frameworks for:
- Cross-border crisis management: The BRRD sets out the mechanisms for co- operation between resolution authorities in applying resolution tools and powers to financial groups operating on a cross-border basis, with an increased role for the European Banking Authority (“EBA”).
- Resolution funds: The BRRD will establish national resolution funds that can be drawn on to cover the costs incurred in connection with the use of resolution powers and tools.
The BRRD was adopted by the European Parliament and the Council of the EU on 15 April 2014 and 6 May 2014 respectively. The BRRD will enter into force on the twentieth day following that of its publication (i.e. 2 July 2014), with the exception of Article 124 which makes consequential amendments to the Capital Requirements Directive IV (“CRD IV”) (2013/36/EU) removing one paragraph relating to recovery and resolution plans and which enters into force on 1 January 2015.
ECB SINGLE SUPERVISORY MECHANISM REGULATIONS PUBLISHED IN THE OFFICIAL JOURNAL OF THE EU
On 14 May 2014, the following Regulations made by the European Central Bank (“ECB”) relating to the single supervisory mechanism (“SSM”) were published in the Official Journal of the EU (“OJ”):
- Regulation (EU) No 468/2014 of the ECB of 16 April 2014 establishing the framework for cooperation within the SSM between the ECB and national competent authorities and with national designated authorities (“SSM Framework Regulation”) (ECB/2014/17).
The SSM Framework Regulation, which was originally published by the ECB in April 2014, lays down the basis for the work of the ECB when it formally commences its SSM supervisory role on 4 November 2014.
- Regulation (EU) No 469/2014 of the ECB of 16 April 2014 amending Regulation (EC) No 2157/1999 on the powers of the European Central Bank to impose sanctions (ECB/1999/4) (ECB/2014/18).
This Regulation clarifies that Regulation 2157/1999 only applies to the imposition of sanctions by the ECB in the exercise of its non-supervisory central bank tasks.
Both regulations enter into force on 15 May 2014. An ECB recommendation (ECB/2014/19), calling for a Council Regulation amending Regulation (EC) No 2532/98 concerning the powers of the ECB to impose sanctions has also been published in the OJ. The Regulation and the Recommendation were both originally published by the ECB in April 2014.
IMPLEMENTING REGULATION ON HYPOTHETICAL CAPITAL OF A CENTRAL COUNTERPARTY UNDER CRR AND EMIR PUBLISHED IN OFFICIAL JOURNAL OF THE EU
On 13 May 2014, the text of Regulation 484/2014, a Commission implementing Regulation on the hypothetical capital of a central counterparty (“CCP”) according to EMIR (the Regulation on over-the-counter (“OTC”) derivatives, CCPs and trade repositories (Regulation 648/2012)) was published in the Official Journal of the EU.
The Regulation sets out:
- The frequency (monthly, weekly or daily) for the calculation of hypothetical capital;
- The frequency (monthly, weekly or daily) for the reporting of the information related to hypothetical capital, provided by a CCP to the institutions acting as its clearing members;
- The conditions based on which the competent authorities of an institution acting as a clearing member can require any CCP, in which this institution acts as a clearing member, to carry out the calculation for hypothetical capital and send the required reports with daily or weekly frequency; and
- The transitional provisions for 2014 on the sending of the reports.
Article 5 of the implementing Regulation states that the Regulation will enter into force on the twentieth day following its publication in the OJ, and will apply from 2 June 2014, except for Articles 1(3), 2(3) and 3, which will apply from 1 January 2015.
The European Banking Authority published final draft implementing technical standards on the hypothetical capital of a CCP in December 2013.