RegTech Intelligence 
JWG analysis.
While the US HFT debate rages and the FBI launches its investigations, Europe is quietly preparing to set a hard-hitting set of new rules for technical standards.
When ESMA begins its consultation around MiFID II / MiFIR tech standards this summer, market participants will need to have their ducks in a row and be ready to engage as quickly as possible to clarify issues that could make life more complicated further down the line. That means time invested over the next few months should hopefully reap dividends and make life easier in 2016, when the rules are due to be implemented.
We’re hoping that existing industry guidance and work by regulators will play a key role in how ESMA crafts its own technical and implementation standards. In that spirit, we’ve gone through some of the upcoming electronic / algo trading tech standards and highlighted three key areas to look out for:
1. Algorithmic trading
The provisions in MiFID II governing investment firms that engage in algorithmic trading are pretty diverse, but here are some of the highlights, along with references to important bodies of work that ESMA may be considering when defining its standards:
a. Systems and risk controls: Firms will need to have adequate controls to ensure their systems are resilient and have sufficient capacity, including business continuity plans, to deal with specific scenarios, along with testing and monitoring procedures. The FOA published a paper outlining best practices on many of these issues, covering everything from testing procedures (including conformance testing, systems capacity, strategy testing, etc.) to business continuity and disaster recovery planning. Hopefully, ESMA’s standards will draw upon the FOA’s guidelines here.
b. Authorisation and notification: Firms will have a host of new papering requirements specifically related to algo trading. These range from notifying relevant NCAs that they are engaged in algo trading to providing detailed descriptions of their algo strategies. Again, the FOA paper includes appendices with detailed descriptions of the kind of information that should be submitted to NCAs. The German HFT Act also lays down relevant provisions for authorising high frequency trading firms, which include capital adequacy provisions – something that falls outside ESMA’s plans.
c. Market making obligations: Firms that pursue market making strategies will be subject to requirements that commit them to providing liquidity for a specified portion of the trading day, barring exceptional circumstances. Of particular note will be how ESMA chooses to define the ‘specified portion’ of the trading day, and the ‘exceptional circumstances’ that would allow electronic market makers to withdraw their quotes. Similarly – market making obligations are referred to in Article 51 of MiFID from the perspective of operators of regulated markets, who will need to ensure they have liquidity providers to support their markets, and clearly set out the benefits that market makers receive in return for their liquidity provision. We expect these obligations will merely be formalising best practices already seen in the market (e.g., current policies operated by exchanges like LSE and Eurex).
d. Direct electronic access: Trading members that provide direct electronic access to markets on behalf of their clients will be subject to new rules that prohibit what has been referred to as ‘naked access’. That means investment firms will need proper systems and controls in place to adequately risk manage clients’ trading activities (both pre-trade and post-trade) and venues will need to provide appropriate services to support those activities (e.g., kill switches, drop copy feeds, etc.). These kinds of controls are all detailed in the FOA paper.
2. Systems resilience, circuit breakers and electronic trading
Article 51 of MiFID is directed principally towards market operators and, while we have covered off a few areas that overlap with the previous algo trading requirements (directed at trading and investment firms), there are several other key areas of note that will impact all market participants, including:
a. Circuit breakers: Market operators will be given the authority to halt trading in a particular financial instrument in the event of unusual volatility (significant price movements during a short period of time) and set parameters for when to instigate those trading halts depending on the liquidity of the instrument in question. Equally, operators of regulated markets will need to inform relevant NCAs when a trading halt is initiated to determine whether trading should also be halted on other markets where that instrument is traded. These requirements seem fairly self-evident to us and hopefully won’t prove too far removed from current practices.
b. Order-to-trade ratios: To ensure regulated markets are resilient and offer adequate systems capacity, market operators will be required to have appropriate controls in place to limit excessive order-to-trade ratios and slow down traffic in the event that system capacity is being reached. Similarly, exchanges will be able to set commercial impediments for excessive quote traffic by imposing additional fees for cancelled orders or to firms that operate excessively high order-to-trade ratios. Again, some of these provisions are detailed in the FOA guidance document, but have already been brought into play by exchanges under the German HFT Act.
c. Algo flagging: To help market operators identify rogue algorithmic trading behaviour, MiFID II also includes provisions that require member firms and participants to flag orders generated algorithmically, along with details of the persons initiating those orders. Similar provisions already exist as part of the German HFT Act, with technical guidance having been offered and revised by exchanges subject to that Act.
3. Tick sizes
Finally, MiFID II also sets out provisions for ESMA to mandate tick size regimes in equities, equity-like instruments and other instruments where such a provision is necessary to ensure fair and orderly markets. Given that most have already signed up to FESE’s standardised tick size regime, we would hope that ESMA doesn’t stray too far from this norm, as even any minor changes could can have fairly significant implications for firms’ trading systems.
The bottom line is that, while we can’t be certain of the consultation details, there is a lot of technical work that can be used in helping to set reasonable expectations for a very tricky set of policies. At long last, the EU’s timing and approach may work to its advantage in helping to calm the global storm created by Mr. Lewis.