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WorldSeptember 29 2014

Europe stretches the rules to reach high-frequency trading

Market participants are disputing attempts by the European Securities and Markets Authority to extend crucial MiFID II rules to address a new political priority.
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What’s happening?

The EU legislation, known as the level-one text, for the vast Markets in Financial Instruments Directive (MiFID II) was agreed between member states and the European Parliament in January 2014. Some weeks later, the controversy around high-frequency trading (HFT) bubbled up dramatically after the publication of Michael Lewis’s book Flash Boys, and the announcement that the US Federal Bureau of Investigation was looking into certain HFT practices as possible market manipulation.

Markus Ferber, the European Parliament rapporteur on MiFID II, said in April 2014 that HFT is “an area that has been absolutely inadequately regulated” until now. “HFT will continue to face more control and transparency, with greater powers for supervisors to intervene,” he said.

What do the rules say?

Written before HFT moved centre-stage in the political debate, the level-one text of MiFID II does not contain many direct references to the subject. However, the European Securities and Markets Authority (ESMA) now appears to be drafting level-two legislation – the regulatory technical standards – with a view to extending obligations on market-makers and trading venues in a way that would allow closer regulation of HFT.

In a discussion paper released in June 2014 on the technical advice it will give to the European Commission under article 48 of MiFID II (on organisational requirements for trading venues), ESMA proposed that trading venues “perform due diligence on all types of entities willing to become members/participants of a trading venue which permits algorithmic trading through its systems”. Under this proposal, any member using something that fulfils ESMA’s definition of an algorithmic strategy must sign a market-making agreement with the exchange. The level-one text requires trading venues to flag algorithms, but does not require venues to identify trader types.

What does the industry say?

The extension of obligations at level two provoked a strong reaction from the industry during the consultation that closed in August. In its response to the ESMA discussion paper, European exchange BATS Chi-X Europe said ESMA “should not seek to impose additional obligations at level two”. BATS Chi-X proposed instead that venues should collect information on who is authorised to cancel trades and who can account for trading activity if questioned, which may not be the traders themselves.

“We understand ESMA’s desire to control HFT, but the market-making obligations are the wrong way to target that. These are commercial agreements for bringing liquidity to assets. It is difficult to see how a venue can force firms to disclose if they are using strategies that ESMA defines as market-making,” says an executive from one European trading venue.

Reporting overload?

The concern about requiring market participants to act as de facto regulators over algorithmic trading was echoed in the banking sector. Swiss investment bank UBS warned about the “stacking of investment firm responsibilities with those of national competent authorities, direct electronic access providers, clearers and trading venues” in an attempt to identify and monitor HFT algorithms.

Reg rage - confusion

“Forcing trading venues and direct electronic access providers to audit or review their counterparties, ie investment firms, in order to be compliant themselves, on top of the primary obligations of investment firms, would mean investment firms may become subject to audits and inquiries from numerous trading venues and service providers, at least twice a year, leading to immense documentary exercises without any tangible benefits,” UBS said.

What is HFT anyway?

There is also confusion over ESMA’s attempt to find definitions for HFT. One of ESMA’s proposed ways of identifying firms employing HFT strategies is identical to a national proposal in Germany – any firm submitting more than 75,000 trade messages per day.

ESMA’s second suggestion was for venues to measure the median daily lifetime of modified or cancelled orders. Firms below the median could be considered as using HFT algorithms. This definition appears to be targeting a particular HFT practice deemed harmful to the healthy operation of the market. This is so-called exploratory trading, where an investment firm sends out a large number of orders intended to be cancelled rather than fulfilled, using the pricing information it obtains from these cancelled orders to detect trading strategies by other market participants.

However, the head of risk at one electronic agency broker believes ESMA’s second definition is unworkable. “There could be no firms that are actually using HFT algorithms on a venue but by definition the venue would still have a median life of cancelled orders and some firms must still fall below that median. Also, an exchange can only compile data at the membership level – they could not see the underlying clients of exchange members,” he says.

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Read more about:  Reg rage , Regulations , Western Europe