On 24 March, as part of the UK’s effort to set rules to transpose the Markets in Financial Instruments Directive (MiFID II), the Prudential Regulation Authority (PRA) set out its proposals in its first consultation paper.
The application deadline for MiFID II/R has been delayed by one-year to 3 January 2018, with just the European Council and Parliament left to approve the legislative amendment as it stands, but Member States are still required to adopt and publish – by 3 July 2016 – the measures transposing MiFID II into national law.
With this in mind, UK regulators have continued to make progress in their transposition of MiFID II into UK law, with the FCA having already published consultation and discussion papers and, now, the PRA issuing their first consultation paper.
The consultation period closes on 27 May 2016 and discusses the changes that the PRA recommends to their rulebook for implementing MiFID II in algorithmic trading and passporting for UK firms. There will be further consultation papers for proposals in other areas in due course.
The PRA’s rules
Whilst there are some areas for which the existing PRA’s rules have been deemed sufficient for transposition purposes, the PRA envisages rulebook amendments to implement the following MiFID II articles:
- Article 16 on organisational requirements
- Article 17 on algorithmic trading
- Articles 34-35 on providing investment services and activities within the EEA.
Other proposals may arise “such as provisions in MiFIR which supersede PRA Rulebook provisions”. The PRA will also suggest proposals on “granting authorisations for new regulated activities under MiFID II”.
In particular, this consultation paper focuses on proposals for:
- the extension of scope and harmonisation of the passporting regime
- systems and controls for firms who undertake algorithmic trading
- systems and controls for firms who provide direct electronic access to trade venues.
These proposals are “relevant to banks, building societies, PRA-designated investment firms and their qualifying parent undertakings, which for this purpose comprise financial holding companies and mixed financial holding companies, as well as credit institutions, PRA-designated investment firms and financial institutions that are subsidiaries of these firms”.
The passporting regime allows firms to provide investment services and carry out investment activities within the EEA without requiring further authorisation.
In general, MiFID II extends the scope of the existing MiFID passporting regime for investment services to include new activities, due to the inclusion of the “operation of an organised trading facility (OTF) and a new category of financial instruments, emissions allowances”.
A firm’s existing MiFID passport will remain valid, although firms will have to assess whether they need to revise their existing passport arrangements to include these new activities or investment types. Firms that intend to passport any additional activities or services must notify the PRA.
However, the PRA is proposing that existing MiFID notification forms should be deleted from the rulebook and that links to new notification forms, approved by the European Commission, should be provided instead. Furthermore, the PRA proposes to extend current passport notification forms under the Capital Requirements Directive IV (CRD IV) to passport notifications made under MiFID II.
- Algorithmic trading
Due to the number of technological developments that have taken place within the trading space regarding algorithmic trading, and high frequency trading (HFT) in particular, new requirements have been set out in Article 17 of MiFID II for firms who engage these types of activity.
As the PRA Rulebook has not specifically focused on algorithmic trading previously, the PRA is proposing to create a new algorithmic trading section within the PRA Rulebook to transpose the requirements under MiFID II. The content of this new section on algorithmic trading is related to, but does not replace, the existing rules on firms’ systems and controls (which are noted within the General Organisational Requirements, Skills, Knowledge and Expertise, Compliance and Internal Audit, Rick Control, Outsourcing and Record Keeping parts of the PRA Rulebook). However, the new section should be read in conjunction with these existing parts of the rulebook.
The rules proposed by the PRA require firms engaging in algorithmic trading to ensure that their trading systems:
- Are resilient and have sufficient capacity
- Are subject to appropriate trading thresholds and limits
- Prevent the sending of erroneous orders or contribute to a disorderly market.
In addition, the PRA proposes that firms should be required to have business continuity arrangements in place in the event of a failure. Furthermore, these arrangements should be “fully tested and monitored”.
The PRA does not consider it proportionate to impose a specific requirement on firms to immediately notify the PRA when they commence algorithmic trading but the notifications section of the rulebook does contain general requirements for firms to notify the PRA of changes to their business. These changes “may include the commencement of, or material changes to, the activities covered by the proposed rules”.
Finally, firms would also be required to “keep records on the nature of their algorithmic trading strategies, details of trading parameters or limits and details on the testing of firms’ systems”.
With HFT being a subsection of algorithmic trading, high frequency traders must follow the requirements for both algorithmic traders and high frequency traders. For those firms engaging in HFT, the PRA proposes more specific record keeping requirements. Overall, where there is a difference in criteria for algorithmic trading and HFT, the “high frequency trader is bound by the stricter of the two rules”.
- Direct electronic access
Finally, the PRA plans to set out proposals to transpose requirements regarding Direct Electronic Access (DEA) to trading venues.
Firms providing DEA services must keep appropriate records and the proposals require firms to put systems and controls in place to:
- Review the appropriateness of clients intending to use this service
- Prevent clients from exceeding appropriate pre-set trading credit thresholds
- Prevent trading by clients, which may create risks to the firm.
The PRA’s proposals are similar to those which the FCA consulted on in December 2015, yet there are also a number of areas where they differ. These differences are especially evident when considering the proposed rules for algorithmic trading provided by each regulator. For instance, the PRA have focused mainly on preventative measures, whereas the FCA have targeted systems and controls. Essentially, this is due to each regulator having different objectives, where the PRA are concerned about the safety and soundness of firms and the FCA’s efforts centre on the prevention of market abuse or disorderly markets.
It should be noted that the PRA’s proposals were published prior to the publication of the final Delegated Acts. However, as the PRA’s proposals are dependent on these Level Two texts, it is stated that changes to these draft rules may be required in order to reflect any relevant changes made to the final texts.
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