by Kiki Pentheroudaki
MiFID II is intended to regulate the use of automated trading to ensure a level-playing field for all market participants. In a two-part overview we will provide you with insight into how regulators are thinking. Part one focuses on the history of automated trading and MiFID’s proposals around market-making for high-frequency traders.
Automated or algorithmic trading is used by a wide range of market participants. Profits from high-speed trading in American stocks were ca. $1.25 billion in 2012, 74% lower than the peak of about $4.9 billion in 2009, according to estimates from brokerage firm Rosenblatt Securities.
According to the Committee of European Securities Regulators (CESR) high frequency trading (HFT) accounts for up to 40% of total share trading in the EU. Studies suggest that HFT using market making and arbitrage strategies has added liquidity to the market, reduced spreads and helped align prices across markets.
On the other hand, there is evidence that the average transaction size has decreased, which makes it difficult for institutional investors to execute large orders. HFT is also linked with the increased use of dark liquidity – i.e. any pool of liquidity, which is not pre-trade transparent such as broker crossing networks and dark pools. Perhaps the most significant new risk arises through the misuse of algorithms (rogue or badly tested algorithms) posing a threat to the orderly functioning of markets in certain circumstances.
MiFID II aims to rectify some of these assumed irregularities by introducing a number of regulatory measures:
- Pushing users of automated trading strategies to be market makers at all times, ensuring they can provide liquidity on a regular basis
- New organisational requirements for firms using algorithmic trading such as robust risk controls to ensure the resilience of their systems, appropriate trading thresholds and limits that will prevent sending erroneous orders
- Authorisation of high-frequency traders at investment firms when they are direct member of a trading venue
- Introduction of minimum resting times for orders sent to an official trading venue
- Intention to move trading away from dark pools
The European Commission’s MiFID consultation paper requires operators of algorithmic trading strategies to “post firm quotes at competitive prices with the result of providing liquidity on a regular and ongoing basis to trading venues at all times, regardless of prevailing market conditions”.
Continuously posting firm quotes can come in two different guises:
- At one extreme, interpreting the requirement that algorithmic traders have to post firm quotes reflecting usual spreads for securities at all times the market is open, could have severe adverse effects on the business model of such traders and potentially drive them out of the market
- On the other hand, if the interpretation of the requirement is designed to mimic the requirements applied currently to official market-makers, the impact on HFT is likely to be minimal
The impact of this market-making requirement will critically depend on how the requirement to ‘continually post firm quotes at competitive prices is interpreted. There will be significant additional risk applied to automated trading if the requirement is interpreted to mean that at all times the market is open, and that every algorithmic trader has to offer to buy and sell a security across a spread that reflects the usual spread for that security.
The push for transparency remains in full force, yet some market participants have questioned the introduction of market making obligations on the grounds that these may cause market makers to quit the market entirely or perhaps transition into other products such as derivatives or bonds. The legislative process is approaching the home stretch and this area will be put under more scrutiny going forward.
Next week’s part two will delve into more regulatory requirements such as authorisation, minimum resting times and the impact on dark pools.