By David Biggin, financial services expert
High frequency and algorithmic trading have come under increased regulatory scrutiny in recent years – not least driven by Michael Lewis’ damning exposé of its murky world in his acclaimed book ‘Flash Boys’. This has been bolstered by recent market volatility that has been attributed to high frequency traders – the volatility in the US treasuries market in October 2014 being a prime example.
Markets in Financial Instruments Directive II (MiFID II), Europe’s regulation focused on protecting big investors, could not fail to cover such emotive and important topics. Aside from any evaluation of their likely effectiveness, the latest texts from Europe should be cause for consternation for many banks and trading houses – even if they might not consider themselves as a dedicated high frequency trading outfit.
Much of the MiFID II response to these issues is covered by legislating for increased transparency – not only of pricing, but of order routing, execution strategies and other potential conflicts of interest in the relationship between the broker, exchange and investor. That said, the actual technology that generates speed, the programmes controlling trading decisions and the firms using them has not been forgotten by regulators. Significantly, any firm considered to have aspects of its business that qualify it as ‘high speed’ or ‘algorithmic’ will need to comply with additional MiFID II rules.
At its heart, the regulation seeks to define what is ‘algorithmic’ and ‘high speed’ – with a firm categorised as ‘algorithmic’ or ‘high frequency algorithmic’. These definitions have been one of the more contentious areas of discussion between the European Securities and Markets Authority (ESMA) and the industry.
Frustratingly, ESMA has left it up to the European Commission to decide whether the latency characteristic or the average lifetime of amended or cancelled orders should constitute the defining measure of a high frequency trading firm. However, according to a recent ESMA study on the matter, the number of investment banks would be largely the same in either option.
If your firm is designated as ‘algorithmic’, you can expect to be faced with a number of additional obligations. This includes extensive testing and assurance of new systems and controls of new algorithms to protect against sending incorrect orders, the algorithm contributing to a disorderly market or any non-compliance of trading rules. You will also need to automatically flag algorithmically-driven trades and reference the algorithm used.
If your firm is designated as ‘high frequency algorithmic’, you will have to share details with National Competent Authorities (NCA) on algorithmic trading strategies, information of the trading parameters or the limits to which the system is subject, the key compliance and risk controls that it has in place, and details of the testing of its systems. High frequency trading firms will also be required to store records of all orders made by algorithmic trading systems and trading algorithms for at least five years.
MiFID II goes a lot further than their US’ counterpart legislation on high frequency trading by the Financial Industry Regulatory Authority (FINRA). By way of comparison, ESMA is proposing accuracy down to the microsecond (one millionth of a second) for clock synchronisation. This is 50,000 times more accurate than FINRA’s requirements which are in the millisecond (one thousandth of a second) range – and a staggering million times (to the nanosecond) increase on the accuracy of timestamping. AFME’s current position is that the industry is only capable of synchronising to 100 microseconds. The cost of implementing these measures cannot be underestimated and need to apply right across your organisation, in every interaction with any exchange – even with systems not engaging in anything considered algorithmic or high frequency algorithmic.
The need to record data linked to execution of orders listed above should be considered a minimum. ESMA additionally states: “Information and data that need to be stored by investment firms that engage in a high frequency algorithmic trading technique should specifically comprise all elements which are necessary to understand and monitor these firms’ trading activity.” This could relate to any number of factors that might be needed to understand the decision an algorithm makes, and potentially, does not make. The potential challenge in meeting the requirements of the regulator should not be taken lightly.
The requirement to share sensitive commercial and proprietary trading strategies may also leave a firm vulnerable to theft and exploitation. Trading algorithms and systems can cost huge sums to develop and firms will need to be reassured that data will be secure.
The biggest risk however, is that these rules are not fully finalised yet. With the Regulatory Technical Standards being delayed and ESMA likely to leave several questions open for the European Commission to answer, firms will likely face running out of time in their implementation programmes if they wait for these standards to start their programmes.
There is plenty of work that can be done now, however, to help firms prepare for MiFID II. This includes performing detailed impact assessments, setting up the required programme structures and defining the work required if companies are deemed a high frequency algorithmic firm. As MiFID II will impact many areas of an organisation, a clear programme structure coupled with strong governance is vital. For high frequency trading requirements specifically, clock synchronisation and timestamping will be a major technical challenge with many firms due to start work in Q3 2015. Prioritising key projects will leave as much time as possible for any further work depending on the final rules definition outcomes.
We have helped several large European investment banks address MiFID II. Our work has included conducting impact assessments, setting up their MiFID II programmes and prioritising the key projects that should begin immediately – with high frequency trading near the top of the list.
 Michael Lewis, Flash Boys, Allen Lane, 2014
 ESMA, High-frequency trading activity in EU equity markets, Number 1, 2014
To find out more about how PA can help your organisation prepare for MiFID II, contact us today.