MiFID II-algorithmic trading, high frequency trading and market making

For the first time, in the European Union, rules on algorithmic and high frequency trading will be imposed on investment firms and trading venues through MiFID II.

What is algorithmic and high frequency trading?

Algorithmic trading encompasses any trading where a computer algorithm automatically determines individual parameters of orders (e.g. initiating, generating, routing and/or executing the order) with no, or limited, human intervention. The definition of algorithmic trading excludes systems that are only used to route orders to trading venues, to process orders where there is no determination of the trading parameters, to confirm orders, or for the post-trade processing of executed transactions.

High frequency trading is a subset of algorithmic trading and is defined as any algorithmic trading technique characterized by the use of infrastructure designed to reduce latency, and the absence of human intervention for initiating, generating, routing or executing orders and high message rates. MiFID II does not specify any limitations in terms of the scope for the determination of high frequency trading. However, based on strong evidence, for the short-term at least, ESMA recommends that the identification of high frequency trading should be limited to investment firms engaging in market making in liquid instruments.

What are the requirements?

Investment firms using algorithmic trading and high frequency trading must:

• Have systems and risk controls to ensure that their trading systems are resilient
• Be subject to appropriate thresholds and limits to prevent erroneous orders or any other problems that may create a disorderly market
• Ensure that their systems are not used to carry out market abuse
• Keep relevant records for five years
• Ensure that their trading systems are tested and monitored (and have appropriate business continuity arrangements in place)

Investment firms will also need to notify their respective regulatory authorities, as well as the regulatory authorities of the trading venues they trade on, that they are using algorithmic trading strategies. If required, further information regarding the trading strategies, trading parameters and limits, and regarding the key compliance and risk controls that an investment firm has in place, must be supplied by investment firms to their regulatory authorities.

In addition, the regulatory authority of a trading venue on which an investment firm is pursuing an algorithmic trading strategy can request the investment firm’s home state regulatory authority to provide it with the information it receives from that same investment firm.

Investment firms engaged in high frequency trading must, in addition to the above:

• Be authorized
• Store time sequenced records of all placed orders (including order cancellations, executions and quotations) for five years
• Make these records available to their respective regulatory authorities (if requested)

In our experience

In the past year, we have seen increased pressure globally from the large statutory bodies on firms taking this particular area of compliance and regulation seriously. In Hong Kong, the SFC issued their specific electronic trading rules in January 2014 and there is no illusion that they expect firms to follow these rules to the letter. The SEC has made serious noise about Algo trading and has for a number of years scrutinized firms’ internal control framework in this area. Closer to home, the FCA has enhanced its internal skillset, and because they are highly skilled at monitoring the markets through transaction reporting using Zen, they clearly have a view on what is going on.

The FCA however, seems to require a more holistic approach to its regulated firms’ response to the wider Market Conduct agenda and wants to see robust controls in all areas of trading/market conduct. This often should start with a market conduct risk assessment. As always with regulation, prevention is better than cure. SFC intervention, for example, tends to be an expensive and time consuming exercise even if there is no formal enforcement action. The FCA clearly has a number of tools at its disposal to force firms to take this seriously. We have seen them use informal quasi S166 style reports to date, and following their recent thematic review we may well see enhanced focus in this area.

Typical areas of review for the regulators

• Electronic trading system flows (e.g. DMA, Algo, Low Latency)
• Algo strategies used including design, development and deployment processes
• Risk limits
• Governance
• Pre-trade controls (including a market impact assessment)
• Post trade controls (including Order and Trade Surveillance)
• System adequacy, resilience and development
• Record Keeping