This is the second in a series of blog posts on MiFID II(Markets in Financial Instruments Directive II). If you missed the first post, seeMiFID II: How Did We Get Here and What Does it Mean?Continuing to review MiFID II, algorithms form the bedrock of modern electronic trading and, unsurprisingly, are of significance in the regulation. This post introduces an overview of the focus of the regulation and its concepts specific to algorithmic trading.
Trading Technologies provides a sophisticated and industry-tested product suite of automated order types and tools including TTs Autospreader, ADL, APIs and synthetic order types, such as OCOs and Icebergs. These order types are in scope under MiFID II. Having reviewed the regulation, it is clear that the bar has been deliberately set at a level to capture a greater swath of automated order types in order to prevent systemic risk and address G20 concerns. Read on for an overview.
ALGORITHMIC SAFEGUARDS: DEFINING BEAUTY, PREVENTING THE BEAST
Regulatory Technical Standards (RTS) 6 and 7 of MiFID II stipulate an array of measures to introduce and standardize the systems and risk controls pertinent to algorithmic trading and to the provision of direct electronic access and due diligence. These measures apply to investment firms, including general clearing members, and trading venues. The nature, scale and complexity of the business model are cited for consideration when addressing efficiency, resilience and adequate capacity.
WHAT IS ALGORITHMIC TRADING TECHNIQUE?
Algorithmic trading is introduced and defined in several key MiFID II sources as comprising trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as [1], [2]:
- 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 purposes of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions.
MiFID II Delegated Regulation stipulates that algorithmic trading should refer to the automated optimization of order execution processes, in addition to the automatic generation of orders. This includes smart order routers (SORs) only in conjunction with the use of algorithms that determine parameters of the order beyond venue identification. It does not include automated order routers (AORs) where they only determine the venue without changing any other parameter of the order[3].
Utilization of such orders types, whether developed in-house or by a third-party, will warrant greater understanding by investment firms, who will be responsible for matters including prior testing, controlled deployment of algorithms to users, and the marketplace (access) and subsequent material changes. Firms will be required to ensure that the time of a material change, its nature, author and approver are recorded.
Trading venues are scheduling their upgraded order and transactional messaging (API) MiFID II compliant specifications for release prior to January 3, 2018. Investment firms will be required to satisfy that their algorithmic order types are appropriately conformance tested, whether trading as a member or through the provision of sponsored access with direct electronic access (DEA) providers, ensuring that the algorithm operates correctly and in accordance with the trading venue and DEA providers own requirements. As a side note, classification of DEA has been subject to differences of opinion by market institutions and participants. In summary, it includes the traditional notion of direct market access (DMA) and sponsored access. In addition to its own client risks and monitoring controls, customers using DEA are obliged to notify the National Competent Authorities (NCAs) of their trading venue memberships or participations and have in place appropriately monitored credit and trading thresholds.
UNDERSTANDING AND DELIVERING PEACE OF MIND
MiFID II seeks to enhanceorder ownershiptransparency with ongoing trading systems pre-trade risk, order cancellation and monitoring capabilities. Real-time visibility to pinpoint which trader or trading desk initiated an algorithm to submit an order to the trading venue will improve situational awareness. Implementation of emergency kill functionality is aimed at preventing potential market disorder. Pre-trade risk controls, including price collars, maximum order value, maximum volume and message limits to the specific trading venues used, are part of the safeguards sought by the EU regulator. In addition, continuous monitoring of credit and market risk exposures reconciled to trading venues and intermediaries, including brokers, are cited. Separately, independent real-time monitoring is already a necessity by the Market Abuse Regulation (MAR) part of MiFID II, which came into effect on July 3, 2016 with the objective of detecting disorderly trading.
KICKING THE TIRES
Investment firms will be required to demonstrate as part of an annual self-assessment stress-testing process the capacity and resilience of their trading systems comprising:
- Running high messaging volume tests using the highest number of messages received and sent during the previous six months, multiplied by two
- Running high trade volume tests using the highest volume of trading reached during the previous six months, multiplied by two
HIGH FREQUENCY TRADING (HFT)
MiFID II tackles HFT as a subset of algorithmic trading technique, subjecting it to the same controls and requirements with additional prerequisites. Prior registration to conduct this type of business and trading model within strict proprietary parameters is required. Prevention of market manipulation is at the core of the regulations objectives.
HFT under MIFID II is described as:
- An infrastructure designed to minimize network and other latencies including high-speed DEA, proximity hosting or colocation for algorithmic order entry.
- System-determination of order initiation, generation, routing or execution without human intervention for individual trades and orders.
- Orders, quotes or cancellations for proprietary dealing in liquid financial instruments and market-making, constituting high message intraday rates[4] which consist of an average of at least two messages per second for a single instrument traded on a venue or at least four messages per second for all instruments across a venue. Client order messages are not counted in the high message intraday rate calculation.
MARKET MAKING
A market-making strategy under MiFID II is characterized as the posting of simultaneous two-way quotes for at least 50% of the daily trading hours, excluding both opening and closing auctions. A written agreement is required to be in place with a trading venue to conduct this type of order business and is a marked change for industry participants who trade algorithmically.
TRADING TECHNOLOGIES SOLUTIONS TO ALGORITHMIC TRADING:
Interpretation of the regulation has led to convergent and divergent views in the industry on key areas within MiFID II algorithmic trading technique. Strategic pragmatism is what drives Trading Technologies approach to facilitating investment firm compliance. From algorithmic workflow design and DEA risk controls to order messaging, audit, and testing, our focus is to keep all eventualities in check.
In my next blog post, I will examine how Trading Technologies algorithm workflows, controls and functionality empower both MiFID II independent algorithm compliance officers and traders with industry-leading capabilities.
[1] Article 4(39), MiFID II Directive.
[2] ESMAs Technical Advice of 19 December 2014 provides that a system shall be considered as having no or limited human intervention (which is indicative of algorithmic trading) where, for any order or quote generation process or any process to optimise order-execution, an automated system makes decisions at any of the stages of initiating, generating, routing or executing orders or quotes according to pre-determined parameters.
[3] ESMAs Technical Advice and MIFID II Delegated Regulation, Art. 18.
[4] MIFID II Art. 4(1)(40).
