New rules on algorithmic trading, such as those quickly approaching from MiFID II, are cause for preparation across the industry, with various regulations in this sphere also impacting the buy-side. So, in this article, we’re going to take a look at some of the ways that regulation is currently, or will soon be, impacting algorithmic trading.
How is algorithmic trading defined? This seems like the first question to answer. There are several key terms around the topic: algo, HFT, colocation – and it helps to have a good grasp of these definitions and how they relate. Algorithmic (or ‘algo’) trading is the use of computers to make and execute the trading decisions based on imputed strategies. A subset of this, as defined in MiFID II, is High Frequency Trading (HFT) which employs technologies, such as colocation, which involves placing servers as close as possible to the exchanges, and high speed networks which allow trading at very high speeds and take advantage of very small windows of opportunity. In fact, HFT can take advantage of opportunities that may only be open for a fraction of a second.
Much of algo and HFT regulation focuses on mitigating the risk of a trading algorithm functioning in a way that could disrupt the market, as well as other ways that they could be employed to unfair advantage.
MiFID II is, no doubt, the regulation that first springs to mind. This game-changing piece of EU regulation enters in to force next January and has a fair amount to say about high frequency trading, creating many new requirements with which to comply. The onus will be more on buy-sides than previously, to share the responsibility for the assessment of the safety and suitability of algos. Both buy-side and sell-side will be required to separately monitor, record and report on the investment decision algorithms and execution algorithms, which must be separately identified. This increase in responsibility and autonomy for execution decisions will mean more scrutiny and accountability. Buy-side firms will be required to have greater transparency on decision-making and execution of orders. In MiFID II, Article 17 covers algorithmic trading stating that “an investment firm that engages in algorithmic trading shall have in place effective systems and risk controls … to ensure that its trading systems are resilient and have sufficient capacity, are subject to appropriate trading thresholds and limits and prevent the sending of erroneous orders or the systems otherwise functioning in a way that may create or contribute to a disorderly market”.
There are several key parts of the new regulation:
Suitable business continuity arrangements in the event of trading system failure
Frequent monitoring and testing of systems, the requirement on buy-side firms to annually assess, check and maintain records of checks on the integrity of their trading systems, ensuring that they maintain systems, risk controls and governance procedures that will prevent disruption to the market by complying with trading thresholds and preventing erroneous orders
The notification to NCAs if firms engage in algorithmic trading and of the trading venues at which they engage in algorithmic trading (if they are using HFAT techniques, they are likely also subject to authorisation requirements)
Gather and store a wide variety of information on their algorithmic trading, including the nature of algorithmic trading strategies, the risk controls in place and further information for High Frequency Algorithmic Trading (HFAT), such as time sequenced records of all placed orders for at least five years. ESMA (European Securities and Markets Authority) suggests that these records need to be sufficiently detailed for monitoring by NCAs and should include information related to the nature of the algorithm, the person accountable for it and key risk controls.
MiFID II contains many organisational requirements to ensure that firms undertaking algorithmic trading have effective systems and controls in place, and that these are suitable for the business. It will be a challenge for many buy-side firms to comply with the increased transparency – in the form of pre-trade checks and assessments and post-trade records – that the new regulation will require of them.
With the arrival of MiFID II in January, the buy-side will have to engage with regulators in new ways in order to comply with new algorithmic rules, ensuring that they have appropriate risk controls, monitoring and records. Although there already exists a fair amount of regulation around the globe for algo, MiFID II will demand more from the buy-side – and the rest of the industry – than ever before, with an unequalled level of complexity and choice with regards to liquidity sourcing and execution decision-making, as regulators move to keep up with the increasing risks and rewards of technological progression in the financial sector.