Algo/HFT Trading - You (MiFID) II
Algorithmic and HFT have grown to sizeable proportions in recent years. However, due to increasing media and political interest, these strategies have received growing regulatory scrutiny.
Regulators are increasingly willing and able to pursue algorithmic traders who manipulate the prices of financial instruments. MiFID II does not disappoint, making specific provisions for firms with these strategies.
It should be noted from the outset that MiFID II does not seek to prohibit either algorithmic trading or HFT; indeed within the recitals, MiFID II extols the benefits of improved trading technology, such as wider participation in markets, increased liquidity, narrower spreads, reduced short term volatility and the means to obtain better execution of orders for clients.
However, in the same breath, it acknowledges that such strategies, particularly of the HFT variety, give rise to a range of potential risks that could lead to disorderly markets or be used for abusive purposes. The measures set out within MiFID II seek to regulate these risks through a variety of means but first we turn to who will be caught by these specific provisions.
The scope Algorithmic trading firms are defined under MiFID II as those who use a computer algorithm which automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order, with limited or no human intervention.
Systems are considered to have no or limited human intervention where, for any order or quote generation process or any process to optimise order-execution, an automated system makes decisions at any of the initiating, generating or routing stages or executing orders or quotes according to pre-determined parameters.
For the purposes of MiFID II, HFT is considered to be a subset of algorithmic trading (and thus subject to the same requirements and controls) and is defined by the following characteristics:
infrastructure intended to minimise network and other types of latencies;
no human intervention in order initiation, generation, routing or execution for individual trades or orders (system-determination); and
high message intraday rate test which constitute orders, quotes or cancellations.1
Any firm whose trading activities meet the characteristics set out above will be deemed to be carrying on HFT activities for the purposes of MiFID II.
Even proprietary traders are within scope of MiFID II if they use HFT strategies, and will have to become authorised with the an EU Regulator as MiFID II explicitly removes the previous ‘dealing on own account’ exemption for high frequency traders. This is a significant change for proprietary traders who have, up until this point, largely been able to eschew regulatory supervision.
Having determined who is caught within the MiFID II definitions, we now look at what that means for firms with algorithmic and HFT strategies and the requirements that have been set out by the European Securities and Markets Authority (“ESMA”) in its Regulatory Technical Standards (“RTS”).
What are the key changes that MiFID II will bring in for our clients with algorithmic and HFT strategies?
1. Governance and organisational requirements (RTS 6)
Regulator notification All algorithmic traders (including high frequency traders) will be required to notify the FCA and relevant trading venue that they engage in algorithmic trading. High frequency traders will additionally be required to record accurate and time sequenced details of each submitted order, including cancelled orders, executed orders and quotations on trading venues for a minimum of five years from the date of submission and must make these records available to the relevant regulator upon request.
Compliance department The compliance function in algorithmic and HFT firms is singled out in that compliance staff are required to have, at a minimum, a general understanding of how the algorithms and trading systems work. This means having access to those in the firm who have a detailed technical understanding of the underlying algorithms and systems. The compliance department must also have access to the ‘emergency stop functionality’.
Staff expertise Firms must have an adequate number of staff with the necessary skillset to manage their algorithmic trading systems and the algorithms themselves. This requisite knowledge encompasses the functionality and monitoring of the systems and algorithms as well as the firm’s regulatory obligations. Staff must therefore be given training on market abuse, a particularly important topic following the introduction of the Market Abuse Regulation (“MAR”).
IT requirements In line with regulatory expectations that algorithmic traders have effective systems and controls in place, such firms will be required to have enacted an IT strategy which implements and maintains reliable IT organisation, security management, cybersecurity, and business, risk and operational elements of the firm.
2. Systems and controls (RTS 6)