The Markets in Financial Instruments Directive (MiFID) is one of the cornerstones of EU financial services law setting out which investment services and activities should be licensed across the EU and the organisational and conduct standards that those providing such services should comply with.
Following technical advice received from the European Securities and Markets Authority (ESMA) and a public consultation, the European Commission (the Commission) published legislative proposals in 2011 to amend MiFID by recasting it as a new Directive (MiFID II1) and a new Regulation (MiFIR2). The legislative proposals were the subject of intense political debate between the European Parliament, the Council of the EU (the Council), and the Commission. However, informal agreement between the EU institutions was finally reached in February 2014. The final MiFID II and MiFIR texts were published in the Official Journal of the EU (OJ) on 12 June 2014 and entered into force 20 days later on 2 July 2014. Entry into application will follow 30 months after entry into force on 3 January 2017.
The implementing measures that will supplement MiFID II and MiFIR will take the form of delegated acts and technical standards. On 22 May 2014, ESMA released a consultation paper (the CP) setting out ESMA’s proposed advice to the Commission regarding delegated acts and a discussion paper (the DP) setting out ESMA’s proposals for technical standards. The deadline for responses to the CP and DP has now closed. ESMA is expected to provide advice on the delegated acts to the Commission by the end of 2014 and drafts of the technical standards by the middle of 2015. The FCA is currently discussing with trade associations and HM Treasury the best way to implement the new legislation in the UK.
Many in the industry cite a number of positives as resulting from high frequency and algorithmic trading, such as creating greater liquidity, lowering costs for investors, increased volume, narrower spreads, reduced short term volatility and better price formation and execution of orders for clients. However, regulators believe that algorithmic trading has the potential to cause rapid and significant market distortion. Specifically there are concerns over the high order cancellation rate, increased risk of overloading systems, increased volatility, the ability of algorithmic traders to withdraw liquidity at any time and insufficient supervision by competent authorities.
MiFID II introduces closer regulation and monitoring of algorithmic trading, imposing new and detailed requirements on algorithmic traders (in certain cases, even where they are exempt from authorisation under MiFID II) and the trading venues on which they trade (including regulated markets (RMs), multilateral trading facilities (MTFs) and organised trading facilities (OTFs)).
Algorithmic trading uses computer algorithms to automatically determine parameters of orders such as whether to initiate the order, the timing, price or how to manage the order after submission, with limited or no human intervention. The concept does not include any system used only for order routing to trading venues, processing orders where no determination of any trading parameters is involved, confirming orders or post-trade processing of transactions.
A firm engaging in algorithmic trading will be required to have in place effective systems and risk controls to ensure its trading systems are resilient and have enough capacity, are subject to appropriate thresholds and limits which prevent sending erroneous orders, do not function in a way that contributes 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. Firms must have effective business continuity arrangements to deal with any system failure and ensure their systems are tested and monitored. The organisational requirements for different types of firm will be further specified in regulatory technical standards.
Trading venues will also be required to have systems to ensure that algorithmic trading cannot create or contribute to disorderly trading on the market and to manage any such conditions that do arise. These will include systems to limit the ratio of unexecuted orders to transactions, slow down order flow and regulate minimum tick sizes. Trading venues will be required to provide facilities for their members to test algorithms. Trading venues will also be required to be able to identify orders generated by algorithmic trading, different algorithms used and the persons initiating the orders.
ESMA’s proposals for regulatory technical standards and delegated acts, as set out in the DP and CP respectively are mainly based on existing regulatory guidance such as its 2012 Guidelines on Systems and Controls in an Automated Trading Environment. When considering the organisational requirements of trading venues and investment firms to be set down in the regulatory technical standards, ESMA proposes that the proportionality principle must be preserved and the nature, scale and complexity of the business must be taken into account. Investment firms should undertake a detailed self-assessment to determine the level of operational requirements that should apply to them. For some algorithmic traders and trading venues many of the technical proposals will be seen as business as usual.
High frequency algorithmic trading
Under MiFID II, high frequency algorithmic trading (HFAT) is a subset of algorithmic trading. A firm engaging in a HFAT technique that currently takes advantage of the exemptions set out in Articles 2(1)(d) or 2(1)(j) MiFID will no longer be able to do so due to the revision of these exemptions under MiFID II. The consequence of this is that, unless such persons are able to fall within another exemption, they will have to become authorised to continue to trade using a HFAT technique.
HFAT investment firms will be required to store time sequenced records of their algorithmic trading systems and trading algorithms for at least five years. ESMA proposes that the records should contain sufficient detail to enable monitoring by Member State competent authorities, and include information such as details of the person in charge of each algorithm, a description of the nature of each decision or execution algorithm and the key compliance and risk controls. The records must be made available to the Member State competent authority on request.
A HFAT technique is one which executes large numbers of transactions in seconds or fractions of a second by using:
- infrastructure that is intended to minimise latencies such as co-location, proximity hosting or high speed direct electronic access;
- system determination of order initiation, generating, routing or execution without human intervention for individual trades or orders; and
- high message intraday rates which constitute orders, quotes or cancellations.
ESMA presents two options for the HFAT definition in the CP. The first is based on the definition of HFAT that the German regulators currently use. It provides easy identification of parameters such as an absolute threshold on message rates. The second captures firms that have a median order lifetime lower than the median lifetime of all orders on the trading venue. Once designated as utilising an HFAT technique on one EU trading venue, that member would be treated as doing so on all EU trading venues.
Market making strategy
Since MiFID was introduced, incidents such as the May 2010 “Flash crash” have led to concerns among lawmakers and regulators that algorithmic traders that act as market makers may cause (or worsen) market disruption by withdrawing from making markets during periods of increased volatility. To address this concern, MiFID II requires a firm that engages in algorithmic trading to pursue a market making strategy to:
- carry on its market making activity continuously during a specified proportion of the trading venue’s trading day, except under exceptional circumstances;
- enter into a written agreement with the trading venue stating their market making obligations; and
- have in place effective systems and controls to ensure that it fulfils its obligations under the agreement.
A firm is pursuing a market making strategy when, as a member of a trading venue, 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, on a regular and frequent basis.
The obligation to enter into agreements with firms pursuing market making activity is also imposed on trading venues. They must have schemes in place to ensure a sufficient number of firms enter into such agreements which require them to post firm quotes at competitive prices, providing liquidity to the market on a regular and predictable basis, where this is appropriate to the nature and scale of trading on that market.
Technical standards will further specify, among other things, the definition of “market making strategy”, the minimum obligations to be specified in a market making agreement (including the relevant proportion of the day) and the exceptional circumstances when quotes need not be shown. ESMA's proposals for the technical standards narrow the definition of market making strategy in some respects, as indirect participants accessing the trading venue via direct electronic access and one sided quotes made on opposite sides of the spread across two different trading venues in the same or related instruments would not be caught by the definition.
The required contents of a market making agreement would be based on principles rather than hard coded conditions. However, ESMA suggests that there would be a minimum set of required parameters (for example, a minimum presence of 80-90% of trading hours, maximum spread, minimum quotation size) without making a definite proposal as to what these parameters should be. ESMA proposes organisational requirements to be imposed on investment firms participating in a market making agreement, including ensuring adequate monitoring of the market making strategy and enabling the investment firms to take appropriate action where unpredictable behavior of the strategy occurs which may have a detrimental effect on the market.
Direct electronic access
Direct electronic access arrangements permit customers of market members to enter orders into a market’s trade matching system for execution using that market member’s trading code, whether or not the market member’s trading infrastructure is used. ESMA considers that systems that allow web based applications where clients transmit orders to a firm in an electronic format to be outside the scope of direct electronic access as long as electronic access to the market is shared with other clients through a common connectivity channel and no specific capacity or latency is provided to any particular client.
A firm providing direct electronic access to a trading venue must have effective systems and controls in place to ensure:
- proper assessment and review of the suitability of clients using the service;
- that clients using the service cannot exceed any pre-set trading and credit thresholds;
- that trading by clients using the service is properly monitored; and
- that appropriate risk controls prevent trading that may create risks to the firm itself or that could create or contribute to a disorderly market.
Direct electronic access without such controls is prohibited and the firm is required to ensure that clients using direct electronic access comply with MiFID II and the rules of the trading venue. It must also monitor the clients to identify suspected market abuse or disorderly trading and report to the Member State competent authority. Additionally, the firm must have in place an agreement with its client setting out their respective rights and obligations.
The technical standards to be developed in relation to algorithmic trading will include specific requirements for direct market access and sponsored access. Investment firms offering direct electronic access are responsible for the trading of their clients and therefore are required to conduct appropriate due diligence on prospective direct electronic access users, including an analysis of all algorithms to be utilised by the client. The controls for sponsored access must be at least equivalent to those for direct market access, including applying all of its usual pre-trade controls to the trading flow of its clients such as setting appropriate trading limits and credit thresholds. Naked or unfiltered access to a trading venue is prohibited under MiFID II.
Trading venues must have in place effective systems, procedures and arrangements to ensure that:
- members are only permitted to provide direct electronic access if they are authorised under MiFID II or CRD IV;
- appropriate criteria are applied regarding the suitability of persons to which access is provided; and
- the market member retains responsibility for orders and trades executed using the service.
Trading venues will also be required to set risk controls and thresholds on trading through direct electronic access. They must be able to stop trading by a person using this method separately from the member’s other trading and to suspend or terminate the provision of direct electronic access by a member. ESMA proposes that this should be achieved by assigning unique IDs to individual users of direct electronic access, allowing the trading firm to identify the origin of an order and block it if necessary. All algorithms will need to be registered by the users with the direct electronic access providers.
Persons who currently take advantage of the exemption under Article 2(1)(d) MiFID will no longer be able to do so under MiFID II, as persons who have direct electronic access to a trading venue will be carved out of this exemption.
Notification to the competent authority
A firm engaging in algorithmic trading or providing direct electronic access must notify its Member State competent authority and that of the trading venue of which it is a member. The firm’s home Member State competent authority may, at any time, require the firm to provide details of the systems and controls it has in place and, in relation to algorithmic trading, a description of the nature of its strategies. This information can be shared with the Member State competent authority of the trading venue. The firm must also keep records to enable the Member State competent authority to monitor its compliance with these requirements.
Where an investment decision is made by an algorithm, that algorithm must be identified in the transaction report sent to the home Member State competent authority. The method of identifying an algorithm is to be set in regulatory technical standards, for which ESMA proposes principals rather than setting prescriptive rules for identification. The responsibility for interpreting those principals would sit with the investment firm.
General clearing members
A firm that acts as a general clearing member will be required to enter into a written agreement with persons to whom clearing services are provided setting out their respective rights and obligations and have systems and controls to ensure that clearing services are only provided to suitable persons who meet certain criteria, such as appropriate credit strength, internal risk controls and trading strategies.
Some of the systems and controls proposed by ESMA reflect EMIR but ESMA also proposes that general clearing members should assess their clients against these criteria on a periodic basis and set monitored trading and position limits with written procedures for breaches to manage their risks against clients.
Further requirements on trading venues
Trading venues are required to have in place effective systems, procedures and arrangements to ensure their systems are resilient and are capable of dealing with peak order and message volumes, ensure orderly trading and are fully tested and subject to effective business continuity arrangements. Trading venues must also ensure they are able to reject orders that exceed pre-determined volume and price thresholds or that are clearly erroneous. There are also requirements in relation to tick sizes and synchronisation of clocks.
Trading venues are additionally required to be able to temporarily halt or constrain trading and in exceptional cases be able to cancel, vary or correct any transaction. These powers must be calibrated in a way that takes into account the liquidity of different asset classes, the nature of the market model and different types of users, and so as to avoid significant disruptions to orderly trading. The intention is that there will be communication between Member State competent authorities and ESMA so that, if a trading venue that is material in terms of the liquidity of a particular instrument, halts trading, this would trigger a process that could result in trading of that instrument being halted on other venues.
Trading venues will be required to give their home Member State competent authority access to their order book on request so that it is able to monitor trading.
Trading venues will also be required to ensure that their rules on co-location are transparent, fair and non-discriminatory. Fee structures must also be transparent, fair and non-discriminatory so as not to create incentives to place, modify or cancel orders or execute transactions in such a way that contributes to disorderly trading or market abuse.
The organisational requirements include testing of algorithms prior to deployment within non-live controlled environments and on an ongoing periodic basis, and rolling out developed algorithms in live environments in a cautious fashion. Investment firms will be required to monitor their systems, processes and procedures to identify any negative impacts algorithms might have, and to be able to cancel all outstanding orders at all trading venues by means of a ‘kill button’. Investment firms and trading venues will be required to have IT environments which meet internationally established standards which are in line with the business and risk strategy of the firm, a reliable IT organisation and effective IT security management. When investment firms procure IT systems, appropriate testing must be undertaken to assess their security and reliability. Where investment firms outsource or procure any IT, firms will need to ensure that their legal and regulatory requirements are met by the vendor.
Investment firms are to have pre-trade controls in place on order submission. Pre-trade risk limits are to be put in place including price collars, maximum order value, maximum order volume, maximum long/short positions, repeated automated execution throttles, kill buttons, outbound message rates, maximum messages limits and where applicable, market maker protections. ESMA proposes that investment firms should be able to automatically block or cancel orders from a trader which is not permitted to trade in a particular instrument and to block or cancel orders which compromise the firm’s own risk management thresholds.