The issue of high frequency trading (HFT) has been the subject of increased attention from regulators across the globe. A number of countries have reacted recently by imposing stricter regulation of HFT activities. 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 EU financial institutions conduct business in the 28 member countries. The changes are designed to reduce 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 Technical Advice. In this extensive consultation, ESMA discusses market-related details pertaining to HFT as well as HFT related definitions.
WHAT IS HFT?
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 analyzes 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 a firm:
- 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 proposed Regulations on Market Abuse.
- They will need to keep adequate records so that information can be provided to the regulator on request.
- Firms engaged in market-making will need to carry out their market-making activities 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 the European Securities and Markets Authority (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 to be introduced.
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 authorized 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.
REGULATING HFT IN THE US
The focus of regulation in the US has been twofold. The SEC and the FBI will investigate how firms use HFT strategies to help regulators identify potential threats of market manipulation, while the CFTC has established a subcommittee of its Technology Advisory Committee to look at the risks posed by HFT. Globally, regulators do not seem to be working towards global convergence on the regulatory oversight of HFT.
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.