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Defining HFT and DEA under MiFID II

By Sam Tyfield and JWG.

Following on from our previous article, the devil is in the definitions, where we unravelled the definitions for High Frequency Trading (HFT) and Direct Electronic Access (DEA) provided within the MiFID II texts, now we explain how these definitions will apply in practice.

What is HFT?

Well, that’s a question to which we all believe we have an answer for: it’s all about infrastructure, messages rates, etc.  The German model, in essence.

But the German model has been interesting in another respect, too.  It was aimed at those firms which were dealing on own account only (we’ll come back to that later).

During a fascinating discussion Sam had recently with Drs Christian (‘40 Under 40’) Voigt and Stephen Taylor, they came up with an interesting hypothesis.  It goes like this:

In the December 2014 Final Report, ESMA included in its technical advice to the Commission that “only proprietary order flow should be considered” as counting towards HFT.  This permits firms to challenge a classification as HFT if some or all of its flow is made up of non-proprietary flow.

Therefore, an agency broker with no prop flow can never be HFT.

So, if a firm based outside the EU (we are deliberately not using the term ‘3rd country firm’ as this has a specific use within MiFID II) sends all of its flow to market via an agency broker, neither the broker nor its client can be considered HFT, as:

• The agency broker’s flow is non-proprietary
• Since the client is intermediated by the broker (one must assume that the client is appropriately intermediated by the insertion of a broker SOR between it and the market, of course), it does not matter whether the client flow has the characteristics of ‘HFT’ or not.

So far, we’ve focused on prop firms based outside the EU who intermediate themselves from the markets using an agency broker, but what about funds and managers?  Is there any entity in the chain which is ‘dealing as principal’?  The Germans fudged the issue by saying that BaFin would investigate each fund and manager individually on its facts to make that determination.

MiFID II is clear that a “collective investment scheme” or its manager, which is a Non-Clearing Member (NCM) of an EU trading venue, is subject to article 17.  Article 17 implies that the NCM itself has a EU home Member State.  That’s all pretty settled.  But what about funds/managers which access markets through DEA or which have all the (other) characteristics of HFT?

• DEA: the simple answer (in principle, although perhaps not in practice, given how having a broker Smart Order Routing (SOR) bolted onto the back-end will affect a strategy) is a broker SOR to intermediate the client and take it out of the World of DEA. If intermediation is not practical, then one must assume that it will not end in a good place for non-EU funds and managers if the direct trading relationship with the EU markets does not have an EU entity authorised and regulated under either MiFID II or AIFMD in it
• HFT: if there is a broker SOR, then client message flow is irrelevant (goes the hypothesis), although, if there is not, the outcome will all depend on the facts, matters and circumstances of the fund set-up. In simple terms, are the investors in the fund closely enough associated with the beneficial owners of the manager to make any dealing by either the fund or the manager ‘proprietary’? We have our own notions of where the boundaries lie –  somewhere between 0% and 100% of common ownership …

What is DEA?

Oh yes – and what is DEA?  There are a number of reasons why it does not seem that a ‘swap’ arrangement where all other characteristics of DEA are present would be bulletproof as a way of preventing ESMA from looking through the swap arrangement.  In light of the hypothesis, perhaps the difficulty faced by swap providers in keeping their clients outside the scrutiny of EU regulators is lessened somewhat if what would bring on the scrutiny are the reports required to be filed only if a firm is HFT.

Here’s hoping that the next round of RTS are released today as planned, although we are slightly worried that the CFTC’s consultation on ‘algorithmic trading’ regulation might be seen first …

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