RegTech Intelligence 
By Anna Reitman, Automated Trader.
Public hearing was a marathon run for industry questions and comments on every aspect of upcoming MiFID II and MiFIR reforms. We highlight a few issues, including market making obligations and requirements that could find direct market access providers identifying clients’ proprietary algorithms.
Paris – As the financial industry prepares to make recommendations for MiFID II and MiFIR regulation, a number of outstanding issues have yet to be resolved.
On July 7, exchanges, brokers, investment firms, trade associations, vendors, issuers and others gathered to get clarity on proposals and begin making comments on the discussion and consultation papers released May 22.
In making decisions about trading obligations for equity and equity-like instruments such as depositary receipts and exchange-traded funds, ESMA will be considering a variety of factors such as average sizes of trades and number, type of active market participants and frequency of trades.
Some of the calculations and definitions that will affect those decisions have been called into question, as has the method of collecting the information. The general response from the ESMA panel was that written submissions pointing out these issues are strongly encouraged.
PJ Di Giammarino, founder and CEO of regulation think tank JWG Group, said the public hearing served as a chance to begin to understand the “brave new world that ESMA has launched us into”.
“They have been wrestling with this tome for over six months and we are as an industry truly on the back foot in terms of being aligned to the way they have interpreted the level 2 mandate,” he said. “The industry’s job is hard as many experts now need to connect the dots laid out by multiple committees that have pursued standards independently.”
“At present, it is a massive effort to get to a meaningful level of understanding about what the real impact will be at a business level, and walking it back through all the controls and compliance and, ultimately, all the necessary data and technology.
“The challenge is that budgets are being set now for the work required to do this right,” he added.
Industry questions
One of the sticking points affecting buy side at the moment is whether internal matching systems, for which there is no regulatory definition, will be required to register as MTFs.
David Lawton, chair of the ESMA panel and director of markets at the UK’s FCA, said it is not the first time the issue has come up, however, it is not part of the set of empowerments granted by the European Commission. “No doubt that will be a question that we will turn to during the course of the development of the implementation plans,” he said.
When it came to the market microstructure panel, representatives of several trade associations questioned the panel on how rules on direct electronic access could impact third countries, the US notably. What obligations will be required?
Moreover, providers of DEA (direct electronic access, which includes direct market access and sponsored access within its definition) will be faced with rules that could require them to identify clients’ proprietary algorithms.
Alberto Garcia, senior officer at ESMA, said that the regulation is intended to identify who exactly is accessing markets. “This has to be addressed, necessarily.”
One participant expressed concerns around any requirements that would force clients to reveal proprietary algorithms. Another noted that being required to share source code with a DEA provider would be problematic.
Di Giammarino noted that this could be one of the cases where ESMA has few options in its own mandate from the European Commission to control market behaviour.
“Ultimately, a person must be responsible for a machine, a machine isn’t something you can hold accountable,” he said. “We are really pushing into new territory in terms of how technology is governed by the law. ESMA will have to make some tough calls that will be eventually looked at in the courts a number of years from now.”
Market making v algo trading
Various aspects of MiFID II refer to market making strategies, agreements and schemes, and how those three concepts interact. In brief, firms running market making strategies are required to sign agreements with trading venues, while trading venues are obligated to maintain a “sufficient number of market makers” to ensure liquidity.
Garcia said: “A trading venue should have some type of scheme so as to incentivise that sufficient number of market makers contribute,” adding, “It is not necessarily a straightforward construction.”
Several stipulations affecting how algorithmic trading is defined and controlled is expected to have major implications for both market makers and HFT firms.
Under Article 17 of MiFID II, algorithmic trading firms will need to provide annual reports to regulators proving that there are proper risk controls and oversight as well as meet a variety of obligations.
One representative from a German trade association requested further clarification on the point: “Do we share the same view that Article 17 is intended to impose new obligations on certain types of market participants which have so far not been under the obligation to provide liquidity on a continuous basis and do we share the same view that (Article 17) is not intended to…inhibit existing hybrid market structures which are based on contracts with investment firms and the market venue which are in place and which are MiFID I compliant?”
ESMA’s Garcia responded that the key point in the text is that “the same performance should be rewarded on a non-discriminatory nature…If there are some quoting obligations that should be rewarded equally across different market making arrangements within the same scheme.”
Chair David Lawton added: “What is in the paper should be considered as a minimum.”
JWG Group’s Di Giammarino said that ESMA’s consultation and discussion papers could receive upwards of a thousand responses by the August 1 deadline.
“There is an awful lot of interest in what is going on here. And it is not just Europe, it is global because a lot of what ESMA is doing cuts across standard industry practice,” he said.