MiFID II: Regulating High Frequency Trading, Other Forms of Algorithmic Trading and Direct Electronic Market Access
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Is high frequency trading (‘HFT’) good or bad for the market? Michael Lewis, in his recent book Flash Boys, paints a far from positive picture of HFT. HFT or flash traders use such advanced techniques that the rest of the market is left trailing in their wake. But, as was to be expected, not everyone agrees with his analysis. In any event, the Markets in Financial Instruments Directive II (‘MiFID II’), which will become binding on the financial sector in the EU/EER as per 3 January 2018, adopts a middle course: it does not prohibit HFT, but it does subject it and other forms of algorithmic trading (‘AT’) to specific supervision as they entail specific risks.
HFT and other forms of AT are not alone in being subjected to a supervision regime in MiFID II. What is now the fairly common practice of investment firms in providing their clients with direct electronic access (‘DEA’) to perform transactions is also subjected to a specific form of supervision. Providers of DEA are now required to ensure that this access complies with the appropriate systems and risk controls.
In my paper, I analyse and discuss the new MiFID II rules on HFT, other forms of AT and DEA. In particular, I discuss the benefits and risks of AT, HFT and DEA, the MiFID II definitions of these terms, the scope of the rules, as well as the applicable substantive rules.
BENEFITS AND RISKS
The benefits and risks of flash trading and other forms of algorithmic trading, in the opinion of the European legislator, are apparent from the preamble to MiFID II. The technology of high frequency trading is said to have provided benefits to the market and market participants generally, such as wider participation in markets, increased liquidity, narrower spreads, reduced short-term volatility and the means to obtain better execution of orders for clients.
Yet, according to MiFID II, this trading technology also gives rise to potential risks, such as an increased risk of the overloading of the systems of trading venues due to large volumes of orders, risks of algorithmic trading generating duplicative or erroneous orders or otherwise malfunctioning in a way that may create a disorderly market. There is also the risk of algorithmic trading systems overreacting to other market events which can exacerbate volatility if there is a pre-existing market problem. Finally, algorithmic trading or high-frequency algorithmic trading techniques can, like any other form of trading, lend themselves to certain forms of behaviour which are prohibited under the Market Abuse Regulation. High-frequency trading may also, because of the information advantage provided to high-frequency traders, prompt investors to choose to execute trades in venues where they can avoid interaction with flash traders.
All in all, MiFID II considers it appropriate to subject high frequency algorithmic trading techniques to particular regulatory scrutiny. Although this mainly concerns techniques which rely on trading on own account, such scrutiny should also apply, according to MiFID II, where the execution of this technique is structured in such a way as to avoid the execution taking place on own account, such as through the transmission of orders between entities within the same group.
The benefits and risks of DEA are not explicitly mentioned in the preamble to MiFID II, but they can be guessed at. A benefit of DEA is that it enables clients to ‘get behind the controls themselves’, without being dependent on an intermediary in the form of an investment firm. But this is also precisely the risk posed by DEA, namely the absence of an expert intermediary in the form of an investment firm, with all the risks that this entails.
By subjecting AT, including HFT, to special supervision, MiFID II recognises that this form of automated trading entails special risks. The same is true of DEA.
It is first of all the AT and HFT traders and DEA providers themselves that are subject to strict supervision. It is noteworthy that DEA providers have a far-reaching responsibility for clients who wish to make use of DEA, which is apparent, for example, from the fact that they must conduct extensive due diligence on their clients.
The operators of trading venues have, in turn, a far-reaching responsibility for the AT and HFT traders whom they admit to their venues – they must, for example, conduct extensive due diligence on these AT and HFT traders before admitting them to the venue. And the responsibility of the operators of the trading venues goes further. They must, among other things, maintain continuous supervision of DEA providers. In fact, the operator of the trading venue serves as a kind of advance guard for the regulator in supervising DEA providers. It will have to be seen in practice how far the responsibility of the various parties actually extends.
A situation in which parties are deterred from entering or remaining in the market must be prevented. This applies in particular to market makers, whose position is presently under pressure for other reasons (eg because the banks must maintain larger buffers for this activity).
Moreover, the AT and HFT traders and trading venues must always determine, by means of self-assessment, whether they comply with the rules. The requirements which this self-assessment must satisfy are fairly detailed. The competent authority can admittedly request information, but the picture which emerges is that of an authority that is quite remote. And if information is provided to the competent authority (whether or not on request), for example the source code of a trading algorithm or an overview of all trading transactions in a given period, we must hope that that the authority has the computer systems necessary to analyse (in the case of transaction data) enormous quantities of data and also the expertise to assess the value of the information and intervene if necessary.
The national competent authorities can in fact achieve the requisite level of knowledge and expertise only through far-reaching cooperation and the exchange of information not only among themselves (both in Europe and internationally) and with ESMA but above all with the sector itself. The sector has every interest in cooperating. After all, fresh scandals or irregularities could lead to even stricter regulation, for example even an outright ban on HFT trading.
Professor Dr Danny Busch, LLM (Utrecht), MJur (Oxon) holds the Chair for Financial Law and is Director of the Institute for Financial Law (IFL), Radboud University (Nijmegen), the Netherlands.
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