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Regulating High-Frequency Trading: New EU Rules

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About The Author

Alex Hitchcock (Former Writer)

Alex is a graduate of the Universities of Sussex and Cambridge. He attained a first-class degree in History from the former before graduating with an MPhil in Modern European History with Distinction from the latter in 2014. He is currently undertaking a full-time internship in the Westminster Office of a Member of Parliament.

In Regulating High-Frequency Trading: The UK, I explored the UK’s regulation of high-frequency algorithmic trading (‘HFAT’). This regulatory framework includes a number of European Union (‘EU’) rules that govern the practice of HFAT in the UK. During the analysis I explained that recent legislation had been passed at EU level, which specifically targets HFAT techniques. The purpose of this article is therefore to analyse these new rules within the context of the problems raised in the last article.

High-Frequency Algorithmic Trading: A Recap

HFAT is the practice of using automated systems to place market orders on exchanges at lightening speed. The speed of these systems (which use high-speed fibre-optic cables to shave milliseconds off the time it takes to place orders) makes it possible to make money by exploiting the discrepancies in financial markets. HFAT is currently involved in around half of all financial securities traded in the USA and Europe.

However, I outlined that high-frequency algorithmic traders (‘HFATers’) have been accused of being involved in a number of questionable trading techniques. What’s more, the algorithms are prone to malfunction and were probably involved in disastrous market crashes in 2010 (the Flash Crash) and 2013 (the Twitter crash).

Unsurprisingly then, HFAT began to draw the attention of regulators. In the UK, the Financial Conduct Authority (‘FCA’) began monitoring the practice closely; it took enforcement action in 2013 in the case of Coscia, pursuant to section 118(5) of the Financial Services and Markets Act 2000 (‘FSMA’) for market abuse.

1. The New European Regimes…

Simultaneously, EU regulators developed a keen interested in HFAT. In July 2014, legislation targeting HFAT came into force. The legislation was divided into two parts: a Directive, Markets in Financial Instruments Directive II (Directive 2014/65/EU) (‘MiFID II’), and a Regulation, Markets in Financial Instruments Regulation (Regulation (EU) No 600/2014) (‘MiFIR’). Member States have until 3 January 2017 to implement MiFID II—the same day which MiFIR (as a Regulation) will automatically become part of UK law.

These instruments will replace the current EU regulatory framework, which stems from the Markets in Financial Instruments Directive (Directive 2004/39/EC) ('MiFID'). The Directive has been in force since November 2007; its aim was to harmonise EU rules on the provision of investment services and the operation of exchanges. Since 2008 the European Commission has worked to update MiFID in light of a changing market that involves more complex trading techniques and technological advances.

MiFID II will largely be transposed into UK domestic law through secondary legislation and FCA rules, via architecture provided by the FSMA.

MiFID II and MiFIR provide a number of general regulations that will affect HFAT. These include:

 

  • Regulation of hitherto unregulated trading venues (including dark pools, voice brokers and interdealer brokers). Article 2 MiFR defines what venues qualify for regulation, Article 20(2) MiFID II requires venues to be authorised by national regulators and Article 20(3) MiFID II requires these venues to abide by the same transparency rules as regulated venues.
  • Prohibition of financial products or activity that may lead to systematic market instability and gives rise to investor protection concerns, as outlined by Articles 31 and 32 MiFIR;
  • The extension of pre- and post-trade transparency (as outlined by MiFID), relating to the details of orders submitted to a trading venue, to cover more than just shares and include bonds, structured finance products, emission allowances and derivatives, as outlined by Articles 8 and 10 MiFIR.

As far at HFAT is concerned, the most radical aspect of MiFID II and MiFIR is the direct regulation of HFAT practices. Whereas there was no mention of ‘high-frequency algorithmic trading’ in MiFID, the term is mentioned 30 times in MiFID II.

This regulation is directed towards both parties involved in HFAT: high-frequency trading firms and trading venues.

1.1. …What They Mean for HFAT Firms

With regard to the high-frequency trading firms, Article 17 MiFID II will provide three important obligations.

First, Article 17(1) states firms must ‘have in place effective systems and risk controls’ to ensure that their trading systems are resilient and have appropriate thresholds and limits to prevent erroneous orders or any other problems that create or contribute to disorder in the market. The firms must also put in place business continuity arrangements in the event of a failed trading. These provisions aim to facilitate the smooth functioning of HFAT practices and make clear the responsibilities of the firms to provide risk controls. Such regulations should therefore stop malfunctioning algorithms, such as the one created by Knight Capital in the US, from causing havoc on the European markets.

Second, firms must notify domestic regulators and trading venues that they are using HFAT practices. Article 17(2) declares that firms must also ‘store 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’, which regulators can request. This provides regulators with powers to monitor the compliance of firms with regards to the above conditions and grants them greater ease of access to high-frequency traders’ actions should foul play be suspected. Crucially, it also avoids the situation where firms have to provide their trading algorithms to regulators. As a British government paper concluded, this would have been unworkable in practice because the sophistication of the algorithms would have been nearly impossible to decode. The request option also sensibly avoids the proposed plans to submit annual disclosures, which would have provided much meaningless information and would have been onerous on firms.

Third, Article 17(3) MiFID II focuses on algorithmic trading firms that pursue a ‘market making strategy’ whereby firms post two-way quotes on trading venues. This requires firms to maintain their market making strategy continuously over a specified proportion of the trading venue’s trading day (except under exceptional circumstances) to provide liquidity on a ‘regular and predictable basis to the trading venue’. It also requires firms to enter a written agreement with trading venues to state their market making obligations and employ systems and controls to ensure the firm meets these obligations. These regulations are intended to stop events such as the Flash Crash—where liquidity disappeared and prices tanked. However, it can be argued that requiring firms to undertake a strategy may negatively affect traders who hope to trade during small parts of the day—‘in the morning, at the close of the day and when there is a major market announcement’, as Professor Niamh Moloney noted when giving evidence in the European Union Committee’s session on MiFID II from 2012.

1.2. …And What They Mean for Trading Venues

Articles 48 and 49 impose three key obligations on trading venues.

First, much like the HFAT firms, trading venues are required to ensure their trading systems are resilient, can deal with peak orders and can function under periods of severe market stress. In practice, this means they are required to have in place a system that rejects orders above pre-determined volume or price thresholds and can cancel obvious, erroneous orders. They must also use circuit breakers to halt or constrain trading during times of extreme price movements. This is an important measure to control extreme fluctuations in price exacerbated by algorithms—such as the Flash Crash and the Twitter crash. As I explained in the last article, the London Stock Exchange and a number of other European stock markets already employ circuit breakers to great effect. However, extension of circuit breakers across the EU is a welcome move to harmonise regulation and trading conditions.

Furthermore, Article 48(5) inserts the provision that in times of extreme distress, European authorities may ‘coordinate a market-wide response and determine whether it is appropriate to halt trading on other venues on which the financial instrument is traded until trading resumes on the original market.’ This is crucially important to stop volatility across disparate markets.

Second, Article 48(9) states trading venues must ensure they do not create incentives to ‘place, modify or cancel orders or to execute transactions in a way which contributes to disorderly trading conditions or market abuse.’ Venues may place higher fees on orders that are then cancelled, or for traders who cancel a large number of orders. This would stop the practices of layering and quote stuffing, explained in the previous article.

Third, Article 49 requires venues to adopt minimum tick sizes for shares and other similar financial instruments. The tick size is the amount by which a trader can raise its quoted offer. Generally, in the USA stocks over $1 are quoted with a minimum tick size of one cent. Currently there is no minimum tick size in Europe and the details regarding Article 49 are still being hammered out by the European Securities and Markets Authority (‘ESMA’); they will be submitted to the European Commission by 3 July 2015. However, it would be wise for the EU to adopt harmonised minimum tick sizes across all trading venues to stop venues from undercutting one another in order to draw trade from those looking to buy lower-priced stocks where the bid-offer spread would be a large proportion of the stock’s value. Tick sizes should therefore strike a balance between being too small and too large, with the latter increasing trading costs by widening the spread between bid and offer prices. But it should err on the smaller side to encourage liquidity and lower the costs for small investors.

2. Extending MAD

MiFID II and MiFIR will also be complemented by the transposition of the EU’s Market Abuse Regulation (‘MAR’), which will replace the Market Abuse Directive (‘MAD’) in July 2016.

MAR continues in MAD’s aim ‘to ensure market integrity and investor protection’ across the EU. However, it widens the scope of MAD to apply to financial instruments on the hitherto unregulated markets, which are set out in MiFID II and MiFIR. It also, like MiFID II and MiFIR, includes over-the-counter financial instruments (which are traded directly between two parties, instead of on trading venues).

Crucially, MAR specifically targets HFAT, in its attempt to ‘provide measures regarding market manipulation that are capable of being adapted to new forms of trading or new strategies that may be abusive’, as stated in its Preamble. Article 12(2)(c) defines market abuse as actions undertaken by HFATs that are not designed to actually trade, but to disrupt or delay the trading system. This will capture the practice of quote stuffing (defined as flooding a market with orders to confuse fellow traders, which causes them to lose their competitive edge). Article 12(2)(c)(iii) also defines market abuse as ‘entering orders to initiate or exacerbate a trend’, which is misleading or false with regards to the supply of, demand for, or price of a financial instrument. This will cover the practice of momentum ignition (defined as placing orders to cause an artificial price movement, tempting other high-frequency traders to react to the movement and exploiting the price change by taking an early position).

MAR is therefore designed to work with the new transparency measures implemented by MiFID II and MiFIR to regulate the more pernicious techniques undertaken by high-frequency traders.

Conclusion

High-frequency algorithmic trading is a highly complicated practice that requires regulators and law makers to be on their toes, across the UK, EU and world.

The previous article concluded that domestically, the UK’s regulation of the practice is fairly comprehensive. Nonetheless, MAR will reinforce the UK legislation and case law by specifically defining market manipulation in the context of HFAT.

New EU measures will also do much to provide better transparency for regulators to monitor these notoriously hard-to-pin-down practices in a pragmatic fashion. The new EU regimes will extend transparency regimes to include a number of extra securities, including bonds. They also follow London Stock Exchange rules to place important requirements on trading venues across the EU, including the requirement to install circuit breakers. The EU was right to implement regulations to directly address problems HFAT may cause.

However, HFAT is a highly complex area to regulate, so only time will tell whether the regulations are adequate. Regulators and lawmakers alike must remain vigilant to ensure that HFAT is not employed in an abusive fashion. This will not be easy, but it is important for market stability and integrity. 

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Tagged: Banking & Finance, Commercial Law, European Union

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