Algo and High Frequency Trading under MiFID2 - a few more pieces in the puzzle

Introduction

Almost two years after MiFID2 was finalised, the European Commission finally published on 25 April 2016 its Delegated Regulation supplementing MiFID2. The Delegated Regulation is a very important part of the Level 2 measures which sit beneath MiFID2. For the purposes of firms that engage in algorithmic trading (Algo) and/or the subset thereof, high frequency algorithmic trading techniques (HFT), the Delegated Regulation provided the final piece in the puzzle by setting out clarification in relation to parts of the definitions of “algorithmic trading” and “high frequency trading technique”. In addition to the Delegated Regulation there are other key Level 2 measures which supplement the MiFID2 Directive and MiFIR. For firms and venues that engage in Algo and/or HFT key provisions are set out in the regulatory technical standards (RTS) published in September 2015, in ESMA’s third final report.

We set out in this note a summary of key Level 2 provisions, as they will affect European Economic Area (EEA) firms/ individuals which engage in Algo and/or HFT. This note will also be relevant to an authorised EU AIFM or UCITS management company, in respect of their "top-up" portfolio management activities governed by MiFID and Non-MiFID and Third Country non-EEA firms which engage in Algo and/or HFT on regulated European trading venues as part of their investment strategy.

Overview of requirements

MiFID2 will significantly alter the way in which Algo and HFT will be regulated in the EU. Not only will firms and individuals that engage in Algo and/or HFT be subject to the new regulatory regime under MiFID2 (which will introduce a number of organisational and conduct requirements, staffing provisions, disclosure, notification and record keeping obligations), they will also have to have in place specific effective systems, procedures and arrangements to ensure resilience and capacity, including testing and monitoring, as well as business continuity plans and mechanisms to control trading - including a “kill function”. Similarly, in addition to the general requirements under MiFID2, trading venues on which Algo and/or HFT takes place (even via non-MiFID firms such as EEA and non-EEA AIFMs) will be subject to additional regulation which may require them to interfere into the trading by slowing down the order flow and reducing the trading activity, by decreasing the number of unexecuted trades as well as requiring a minimum tick size and, in certain limited circumstances, operate a “kill function”.

These changes will impose considerable financial, IT and personnel cost on firms and many caught by these requirements have begun the process of considering the implications on their internal systems and processes. Set out below is a summary of some of the key requirements set out at Level 2 and what actions firms could be considering for compliance.

Scope

Algorithmic trading

There has been much debate about the scope of Algo trading1. The Delegated Regulation clarifies that a system has "no or limited human intervention" where "for any order an automated system makes decisions at any of the stages of initiating, generating, routing or executing orders or quotes according to pre-determined parameters". This means that even trading techniques which are not wholly automated but where algorithms are used for part of the investment process may be within scope and raises the question as to what extent human intervention is required in order for trading not to be Algo.

The Delegated Regulation further clarifies Algo should refer not only to the automatic generation of orders but also to the optimisation of execution processes by automated means. It goes on to state that Algo should encompass smart order routers (SORs) where such devices use algorithms for optimisation of that determine parameters of the order other than the venue or venues where the order should be submitted but confirms that automated order routers (AORs) which, although they use algorithms, only determine the trading venue or venues where the order should be submitted, are outside of scope. Lastly, the Delegated Regulation makes it clear that the trading processes based on "direct electronic access" (DEA) are not mutually exclusive to Algo (or its subset HFT) and therefore the trading of a person who has DEA may fall under the definition of Algo (including HFT).

High frequency algorithmic trading

HFT is under MiFID2 a subset of Algo characterised by, amongst other things "high message intraday rates which constitute orders, quotes or cancellations"2.

"High frequency algorithmic trading technique" means an algorithmic trading technique characterised by:

• infrastructure to minimise network and other types of latencies, including at least one of the following facilities for algorithmic order entry: co-location, proximity, hosing or high-speed direct electronic access
• system determination of order initiation, generation, routing or execution without human intervention for individual trades or orders, and
• high message intraday rates which constitute orders, quotes or cancellations’ Article 4(1)(40) of Directive 2014/65/EU.

After much uncertainty during the consultation and reporting process, the Delegated Regulation makes the welcome clarification that "a high message intraday rate" shall consist of the submission on average of: (a) at least two messages per second with respect to any single financial instrument traded on a trading venue; or (b) at least four messages per second with respect to all financial instruments traded on a trading venue.

Messages must be for the purpose of Algo and only instruments for which there are a liquid market (as defined in MiFIR) should be included in the calculation. Furthermore, only messages introduced for the purposes of dealing on own account, and not those introduced for the purposes of receiving and transmitting orders or executing on behalf of clients, should be included in the calculation (subject to a general anti-avoidance provision that if the firm’s execution technique is structured in such a way to avoid that execution takes place on own account - such as transmission of orders between entities of the same group). For firms providing direct electronic access (DEA), messages which were originated by clients for such services should be excluded from the calculation by such firms.

For the purposes of the above calculations trading venues shall make available to firms on request estimates of average messages per second on a monthly basis two weeks after the end of each calendar month taking into account all messages submitted during the previous 12 months.

Firms which trade on their own account and which do fall within the definition of HFT should remember that (unlike the current situation under MiFID1) they will fall within the scope of MiFID2 and will therefore have to be appropriately authorised by their competent authority.

Algorithmic trading notification requirement

Under MIFID2, a firm which engages in Algo will be required to notify its regulator that it (1) is engaging in algorithmic trading and (2) the trading venue(s) on which the firm engage Algo. The regulator may require the firm, on a regular or ad hoc basis, to provide the following:

• a description of the nature of its algorithmic trading strategies
• details of the trading parameters or limits to which the system is subject
• the key compliance and risk controls the firm has in place to ensure the conditions in the points above are satisfied, and/or
• details of testing of its systems.

It remains unclear whether firms engaging in Algo will be required to disclose commercially sensitive details (such as formulae, source code, etc.) and this may boil down to a question of how individual regulators implement into their national law.

Organisational and risk control requirements

ESMA’s proposed RTS set out specific organisation and risk control requirements for firms which engage in algorithmic trading in relation to:

• resilience of trading systems, including testing of algorithms and systems (see below)
• real-time monitoring which shall, during the hours they are sending orders to trading venues, monitor in real time all algorithmic trading activity that takes place under their code, including that of their clients, for signs of disorderly trading, including from a cross-market, cross-asset class, or cross-product perspective, in cases where the firm or its clients engage in such activities
• a “kill functionality” to be able to cancel all outstanding orders at all trading venues, embedded in both the firm’s own systems as well as those of the trading venue, and a separate capability to cancel orders at individual trading venues or originating from individual traders, trading desks or, where applicable, clients
• business continuity arrangements including duplication of hardware to permit continuous operation which shall be reviewed on an annual basis
• pre-trade controls on order entry and post-trade controls, and
• appropriate arrangements for physical and electronic security.

Testing

MiFID2 will introduce general requirements of algorithms and systems, including development and testing methodologies (and certain specific requirements in relation to the testing of “investment algorithms” and the environments used for the testing thereof) and recordkeeping.

Such firms will also have to test the conformance of their trading systems and algorithms with the trading venue when (i) accessing the venue; (ii) connecting to the venue through a sponsored access arrangement for the first time; (iii) when there is a material change of the systems of the trading venue; (iv) prior to the initial deployment or material update of an algorithmic trading system, trading algorithm or algorithmic trading strategy. They will also have to maintain control over trading algorithms employed by setting limits on the number of financial instruments being traded, on the price, value and numbers of orders, on the strategy positions, and on the number of trading venues to which orders are sent.

Investment firms will have to perform an annual self-assessment and validation process of system to review and evaluate firms’ algorithmic trading systems and trading algorithms, governance, accountability and sign-off framework and relevant business continuity and their overall compliance. As part of this assessment, investment firms will have to perform stress testing, which shall at least consist of the following:

• running high messaging volume tests using at least twice the highest volume of messaging received and sent by the firm over the previous six month period
• running high trade volume tests using at least twice the highest volume of trading reached by the firm over the previous six month period.

The self-assessment shall at least include an analysis of all the parameters set out in ESMA’s RTS 6. The validation report of the annual self-assessment will have to be audited by the firm’s internal audit function (if any) and be approved by the firm’s senior management.

Recording

Firms which engage in Algo will have to keep certain records in relation to the algorithms responsible for the investment decision and the execution of an order (as part of the general record-keeping requirements applicable to all firms). Those firms which employ HFT will be required to record certain prescribed details of each placed order (28 fields for each decision to buy/sell; 35 fields for each outgoing and executed order immediately and maintain that information in the standards and formats prescribed by Annex III of RTS 6.

Governance, compliance and staff

In addition to the risk controls and processes set out above, firms will be required to have in place specific staff policies, expertise and training in relation to algorithmic trading. These requirements include:

• Specific role of compliance staff:
  • to have at least a general understanding of the way in which the algorithmic trading systems and algorithms of the investment firm operate
  • to be in continuous contact with persons with detailed technical knowledge of the firm's algorithmic trading systems or algorithms, and
  • to have access to kill functionality or persons who have access to kill functionality.
• Specific arrangements to extent outsource compliance function which include terms of agreement to ensure that data privacy is protected and auditing is not constrained.
• Staff policies and procedures to ensure firm employs an adequate number of staff with the necessary skills to manage their algorithmic trading systems and trading algorithms and sufficient technical knowledge of:
  • relevant trading systems and algorithms
  • the monitoring and testing of such systems and algorithms
  • the trading strategies that the firm deploys through its algorithmic trading systems and algorithms, and
  • the investment firm's legal and regulatory obligations.

Staff are required to undergo suitable training to ensure they are adequately informed of their obligations and have an understanding of what constitutes market abuse or disorderly trading conditions.

Obligations of trading venues

Under MiFID2 trading venues allowing or enabling algorithmic trading will be subject to new systems resilience and "circuit breaker" requirements that will have an impact on firms (including non-MiFID and Third Country firms) trading on those markets. In particular, trading venues will need to have in place effective systems, procedures and arrangements in order to ensure such venues:

• on an annual basis they carry out a self-assessment of their compliance and store records of such assessments for at least five years
• perform due diligence on members using systems
• have in place testing methodologies to ensure trading system does not behave in an unintended manner
• have sufficient capacity to accommodate at least twice their historical peak of messages
• ensure their systems are monitored and reviewed on an ongoing basis
• carry out periodic reviews of systems and performance capacity is carried out annually and any deficiencies remedied promptly
• have in place business continuity arrangements to address disruptive incidents and have in place effective business continuity plans
• ensure they are able to reject orders that exceed pre-determined volume and price thresholds or are clearly erroneous
• ensure orderly trading under conditions of severe market stress by imposing ‘throttle limits’ and pre and post trade controls, and
• ensure they can, where necessary, halt or constrain trading which will include a manual “kill functionality” which, when activated, will disable the ability of a member or participant to trade and will cancel all resting orders of that firm.

Members of such trading venues will be required to carry out appropriate on-site testing of algorithms (including conformance testing) to avoid disorderly trading conditions.

Trading venues will be required to make available upon request from firms potentially in scope of HFT estimates of messages per second on a monthly basis two weeks after the end of each calendar month taking into account all messages submitted during the preceding 12 months to those firms which request such information for the purpose of determining whether their trading strategy has “high intraday rates”.

Firms pursuing a market making strategy

A firm which engages in Algo to pursue a market making strategy shall, taking into account the liquidity, scale and nature of the specific market and the characteristics of the instruments traded:

• carry out this market making continuously during a specified portion of the trading venue’s trading hours, except under exceptional circumstances, with the result of providing liquidity on a regular and periodic basis to the trading venue
• enter into a binding written Market Maker Agreement (MMA) with the trading venue which shall at least specify the obligations of the firm and the list of exceptional circumstances referred to above (ESMA’s RTS sets out minimum content requirements for such agreements), and
• have in place effective systems and controls to ensure that it fulfils its obligations under that binding MMA.

A firm which engages in Algo shall be considered to pursue a market making strategy when, as a member or participant of one or more trading venues, its strategy, when dealing on its own account, involves posting firm, simultaneous two-way quotes of comparable size and at competitive prices relating to one or more financial instruments on a single trading venue or across different trading venues for no less than 50% of the daily trading hours of continuous trading at the respective trading venue, excluding opening and closing auctions, for half of the trading days over a one month period.

For the purposes of the above definition:

• a firm quote shall include any orders and quotes that can be matched against an opposite order or quote under the rules of a trading venue
• quotes shall be deemed simultaneous two-way quotes if they are posted in a way that both sides are present in the order book at the same time
• two quotes shall be deemed of comparable size when their sizes do not diverge by more than 50% from each other
• quotes shall be deemed to have competitive prices where they are posted at or within the maximum bid-ask range set by the trading venue and imposed upon every investment firm signing a market making agreement.

Status of Level 2 material

Delegated Regulation The European Commission published the draft Delegated Regulation on 25 April 2016. The European Council and Parliament now have three months in which to scrutinise the Act - which can be extended to six months on application of either of these institutions. If no objections are made, prior to or at the end of the scrutiny period, the Delegated Regulation will be published in the Official Journal and formally enter into force twenty days later. The Delegated Regulation will apply from the date of the introduction of MiFID2, currently expected to be 03 January 2018. As an EU regulation (and unlike a directive), the Delegated Regulation will not need to be implemented into the national law and regulation of EU member states. Instead, it will apply directly across the EU to all MiFID investment firms on a harmonised basis.

Regulatory Technical Standards ESMA published drafts of the Regulatory Technical Standards (RTS) in September 2015, in its third final report. The European Council and Parliament then had three months in which to scrutinise and object to the RTS (which can be extended by a further three months). The extension of MiFID2/MiIFR application date to 03 January 2018 and the re-drafting of parts of Level 1 has caused significant delay in the approval and adoption of Level 2 measures. So far, the European Commission has asked ESMA to re-draft a number of RTS published in September 2015 none of which relate to HFT or algorithmic trading specifically. Therefore the expectation is that ESMA’s RTS will be adopted over the coming months. The RTS will be enacted as delegated acts and, once published in the Official Journal, will be called Commission Delegated Regulations. As with the draft Delegated Regulation, they will not need to be implemented into the national law and regulation of EU member states. Instead, they will apply directly across the EU to all MiFID investment firms on a harmonised basis.

Will Member States be “gold-plating”?

Algorithmic trading and HFT are subject to enhanced scrutiny by European regulators and it is likely we will see some Member States applying additional regulation at a national level in the future. To date, Germany has been the main jurisdiction which has led the way with the regulation of HFT, though France also imposes a number of requirements on firms or individuals which engage in algorithmic trading.

In the UK, the FCA published in December 2015, its first FCA Consultation Paper CP 15/43 on the implementation of MiFID2 (FCA CP), In the FCA CP, the FCA sets out its proposed handbook changes to implement MiFID2 algorithmic and HFT requirements which suggests that the FCA plans to extend the requirements to AIFMs and UCITS ManCos in respect of their non-AIF/UCITS business.

Impact on firms

Firms caught by these new requirements will need to ensure they have systems and controls in place that satisfy the regulator that its trading systems meet numerous requirements, the highlights of which include:

• organisational systems and risk controls
• notifications to the regulator
• disclosure of information to the regulator about algorithmic trading, such as a description of the nature of its algorithmic trading strategies, compliance and risk controls, and details of systems testing
• flagging of orders created by algorithms and record keeping, including time sequenced records of all placed orders, cancelled orders, executed orders and quotations on trading venues to be stored in an approved form
• obligation to carry out any market making continuously during a specified proportion of the trading venue’s trading hours to provide liquidity on a regular and predictable basis to the trading venue, and
• stringent staff, compliance and management functions and oversight.

In addition, such firms will be required to subject their algorithms to stringent testing and keep detailed records of their trading for a period of five years.

Non-MiFID firms (including AIFMs and Third Country firms) which employ Algo and/or HFT techniques on a trading venue will be subject to the new mechanisms, processes and controls which such venues are required to implement under MiFID2, including on-site testing of algorithms to avoid disorderly trading conditions, capacity and monitoring obligations and trade controls (including pre-trade controls and “kill functionality”). It is likely that firms will be required to provide additional information and assurances to trading venues on which they carry out algorithmic trading. In addition, it may be likely that trading venues will charge higher fees on firms operating an Algo and/or HFT technique. Such firms should consider the potential impact these changes may have on their European trading strategies.

What should firms be thinking about?

For much of 2015 and the first part of 2016, the most commonly heard answer to the question “What next on MiFID2” was “Wait and see...”. Wait to see if the delay to January 2018 would be confirmed and wait for the delegated acts (the key pieces of which have now fallen into place). To the extent that they have not already done so, firms should now be thinking of refocusing on their MiFID2 implementation projects.

Now, with the publication of the Delegated Regulation, all firms (including non-MiFID firms) are now in a position to determine whether their trading strategies involve Algo and/or HFT.

Firms subject to MiFID2 (which currently includes UK AIFMs in respect of any “top-up” activities) should be reviewing their existing systems and analysing how they will be able to incorporate the new organisational, conduct, risk controls and staff requirements into their business.

To the extent that a firm employs Algo and/or HFT on a trading venue regulated under MiFID2, such a firm should review what steps those trading venues will be taking in order to comply with MiFID2.

All firms should fully benchmark the detailed requirements set out in the relevant RTS published by ESMA and how it will affect their business and what steps they need to take to reach full compliance by January 2018.

Firms may also wish to consider using the Simmons & Simmons MiFID2 Manager tool. The MiFID2 Manager is a practical tool to guide you through the steps that need to be taken to stay on top of the requirements of MiFID2/MiFIR and its implementing legislation.

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 1"algorithmic trading" means trading in financial instruments where a computer algorithm automatically determines individual parameters of orders 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, and does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions’ Article 4(1)(39) of Directive 2014/65/EU.

2 "high frequency algorithmic trading technique" means an algorithmic trading technique characterised by:

• infrastructure to minimise network and other types of latencies, including at least one of the following facilities for algorithmic order entry: co-location, proximity, hosing or high-speed direct electronic access
• system determination of order initiation, generation, routing or execution without human intervention for individual trades or orders, and
• high message intraday rates which constitute orders, quotes or cancellations’ Article 4(1)(40) of Directive 2014/65/EU.