Today’s European financial markets hardly look like the ones from 10 years ago. Financial Markets are definitely more complex: high speed of electronic trading, wide range and complexity of financial instruments, explosion in trading volumes, fragmentation of trading venues and proliferation of OTC trading activity.
The impact of the latest financial crisis has forced Regulators globally to take an action and a new set of regulations has been released. MiFID II is, no doubt, the regulation that first springs to mind talking about Capital Markets.
Entered into force on January this year, MiFID II has on one side reinforced the financial market infrastructure, among all: introduction of the OTFs to capture OTC trading activities, trading obligation on equity and standardized derivatives, new transparency regime, a new information package available, strengthening reporting activity to competent authorities. On the other side, and this is the most innovative part, MiFID II has answered the need to discipline technological developments in trading, particularly Algorithmic and High Frequency Trading (HFT).
The new market structure – Key innovations
MiFID II brings important changes in the market structure of European capital markets to basically increase transparency of the trading and to restrict over the counter trading.
A third category of trading venue the Organised Trading Facilities (OTFs) sit now alongside the Regulated Markets (RMs) and Multilateral Trading Facilities (MTFs). OTFs have been introduced to push OTC trading platforms within the regulatory system (as already started in MiFID I with MTFs introduction) and capture the trading in non-equity instruments such as bonds, structured finance products, emissions allowances and derivatives currently not conducted via RMs and MTFs. Organized Trading Facilities are multilateral systems with characteristics that distinguish them from RMs and MTFs. Like RMs and MTFs, OTFs may not execute orders against proprietary capital (except trading in sovereign bonds). In contrast a firm operating on an OTF can exercise discretion when deciding to place or retract an order on the OTF they operate and subject to certain requirements when deciding not to match client orders.
MiFID II increases market transparency by ruling the practice of trading in shares admitted to trading on an RM or traded on an MTF only on an RM, MTF, Systematic Internalizers (SIs) or equivalent third-country trading venue and by forcing derivatives trading on trading venues decreasing the OTC execution.
Pre- and post-trade transparency requirements have been extended to non-equity instruments (i.e. bonds, structured finance products and derivatives) and equity like instruments under MiFID II. As a result of these extended transparency requirements, more information will be available to the public on trading in financial instruments both pre-execution (quotes and pricing) and post-execution. The regulator has also demanded more reporting requirements by expanding the transaction reporting regime, both on the scope of financial instruments captured and on the data fields to include in the report (up to 65 fields).
Algorithmic trading in the new trading landscape: an unavoidable future to be monitored and controlled
There have been many so-called “flash-crashes” during the last decade caused by the activity of algorithmic trading. Michael Lewis in “Flash Boys” describes the father of all these events that occurred in the Dow Jones market on May 6, 2010. The Dow Jones collapsed and rebounded very rapidly losing immediately a thousand points, almost 10%, sending market operators into panic. The movement was caused by a single order of futures on the S&P 500 index that triggered sell algorithms and generated a rapid decline and recovery in the price of financial instruments.
Fostering trading activity on electronic trading venues is a way to spread transparency and financial stability. Regulators are aware that algorithmic trading activity, that limits or excludes human intervention, could be a threat for orderly trading conditions as it could generate market abuse and manipulation. For these reasons, MiFID II introduces new requirements to ensure that investment firm will be able to control and monitor their algorithmic trading activity. The Directive considers the benefits of improved trading technology but acknowledges that such strategies, particularly of the HFT variety, give rise to potential risks that could lead to disorderly markets or be used for abusive purposes and therefore must be strictly monitored and regulated.
The algorithmic trading activity could be engaged by an investment firm to generate:
- orders for proprietary trading, including bid-ask quotes published for the market making activity;
- orders on behalf of a client, especially to execute an high size order with TWAP or VWAP functionalities, and implement one or more of the following strategies: market making or liquidity providing, hedging or arbitrage.
The most common trading strategy in scope of algorithmic trading for investment firms is the market making activity, because bid-ask quotes are generated automatically during the trading day and published continuously on trading venues. Moreover, an investment firm sometimes develops proprietary market adapters to generate orders on the trading venues with their own algorithms, other times it uses provider’s platform to pursue trading algorithmic technique and algorithms could be:
- embedded in provider’s trading platform;
- developed by the investment firm in dedicated spaces made available by the supplier;
- elaborated by the supplier according to investment firm’s needs.
Additionally, MiFID II defines high frequency trading (HFT) as a subset of algorithmic trading characterized simultaneously by:
- infrastructure intended to minimize network and other types of latencies, including at least co-location, proximity hosting or high-speed direct electronic access;
- order initiation, generation, routing or execution without human intervention;
- high message intraday rates which constitute orders, quotes or cancellations. The rates are evaluated monthly with a moving average according to all messages sent during the previous year considering only proprietary trading (and including market making quotes).
MiFID II requires firms understand the impact their algorithms will have on the marketplace, including the reaction of other algorithms active in the segment. MiFID II requires all trading firms to certify that their algorithms have been tested to ensure that they do not create or contribute to disorderly trading conditions before being deployed in live markets. New requirements for investment firms engaged in algorithmic trading are:
- general organizational requirements: formalization of specific governance arrangements about trading systems and algorithms proportionate to the nature, scale and complexity of the activity;
- algorithms pre-deployment requirements: investment firms are required to establish a written procedure for developing, modifying, testing and deploying an algorithm in the production environment;
- algorithms post-deployment requirements: investment firms have to structure means and controls to ensure resilience of trading systems and algorithms during the trading activity. The functionalities an investment firm has to develop are:
- the kill functionality to ensure the cancellation of any or all of unexecuted orders submitted to any or all trading venues to which the investment firm is connected;
- the automated surveillance system to detect market abuse;
- business continuity arrangements;
- the pre-trade controls on price, message limits, order values and volumes to prevent the transmission of wrong orders or quotes to trading venues;
- the real time monitoring with real time alerts to assist traders during the trading activity;
- the post trade controls to identify algorithms or systems which are not working in the correct way;
- cyber security arrangements;
- periodic requirements: investment firms have to self-assess annually their algorithmic trading activity and consequently the risk management function has to draw up a validation report.
HFTs firms have more strictly requirements because they need the authorization to operate as investment firms and have to store accurate and time sequenced records of all its placed orders and quotes using a defined format (also algo traders have to record all this information, but they are not obliged to use the format set out in the regulation).
One of MiFID II aim is to create more efficient financial instruments order execution in price-competitive, transparent and stable markets. The innovations in trading venues is a mechanism to strengthen also investor protections. From this perspective, not only where but also how investment firms carry on the trading activity needs to have appropriate organizational and IT arrangements. The MiFID II framework regulates algorithmic trading activity because freedom could create damages to the economic system just because an automated mechanism could go crazy for distressed information. All investment firms have to understand and copy with technological challenge to ensure their algo trading activity is sound, efficient and secure. Will the new requirements prevent algorithmic trading, especially HFT, to generate other cases of flash crash? How many algo traders will qualify their activity as high frequency trading? We will find out soon.
Alessandro Mastrantuono – Director Deloitte Consulting
Gabriele Bonini – Manager Deloitte Consulting
Valeria Mij – Manager Deloitte Consulting
Francesco Ciarambino – Analyst Deloitte Consulting
 ESMA’s Final report (ESMA70-156-227) provides details to derivatives subject to new trading obligations (intragroup transactions are exempt from this trading obligation)
 MiFID II defines algorithmic trading as “the trading activity in financial instruments on a trading venue where a computer algorithm automatically determines individual parameters of orders (including quotes) such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention”
 Time weighted average price (TWAP) strategy breaks up a large order into child orders and execute them close to the average price between the start and end times.
 Volume weighted average price (VWAP) strategy breaks up a large order into child orders and execute them close to the average price weighted by volume between the start and end times.