MiFID II – Trade Automation, Part 2

by Kiki Pentheroudaki 

We have discussed the historic development of automated trading and how regulators are pushing high-frequency traders to become market makers. We now want to look at further ways to regulate automated trading under MiFID II.

The impact of high frequency trading (HFT) flow on markets will also see continued attention from market participants and regulators alike. In 2012, significant regulatory attention focused on HFT, such as provisions in the European Parliament's version of MiFID II. The document called for venues to instate order-to-trade ratios, a 500 millisecond minimum resting time for orders, and a ban of the maker-taker pricing model, which rewards posting passive liquidity but can lead to potential conflicts of interest among market participants.

For HFT there are concerns that not all high frequency traders are currently required to be authorised under MiFID as the exemption in Article 2.1(d) of the framework directive for persons who are only dealing on their own account can be used by such traders. While HFT represents an increasing and substantial share of market transactions and the liquidity they provide to the market may replace the more traditional market making activities, high frequency traders have no incentive or obligation to continue to provide ongoing liquidity in a distressed market situation unlike registered market makers.

High-frequency traders usually remain in the market for a mere blink of an eye but this restriction – an introduction of the 500 millisecond latency in a bid to make a stand - against the rise of high-frequency trading could significantly alter the way they operate and could also have unintended consequences for the wider market.

The HFT community says that Brussels’ plans will result in less liquidity and wider spreads for other market participants, while some in the market believe HFT will likely benefit from the move anyway as they will just pinpoint 499 and 501 milliseconds in the future to generate their profits (the original MiFID regulation made no such provision).

From a wider regulatory perspective, the CFTC and SEC are currently reviewing rules on Automated Trading and HFT. They are working together with the markets to consider recalibrating the existing market-wide circuit breakers. The CFTC has published proposals targeted at specialist automatic trading rules as part of the rules for the newly introduced Swap Dealers and Major Swap Participants. Persons involved in "automated and high frequency trading" who are direct members of a regulated market or MTF will be required to be authorised and supervised as investment firms. There will be specialist rules for firms involved in algorithmic trading including compliance, risk controls, and notification to regulators of algorithms. In addition firms will be required to flag the use of algorithms in transactions and orders.

Several concerns have been raised regarding the very broad scope of the proposed provisions, in particular on the obligation for algorithmic traders to provide liquidity at all times, and the legal uncertainty that would be created by the fact to leave the specification of the scope of this provision to delegated acts. Independent investors said they hoped MiFID II would shield them from HFT practices, which are often accused of distorting stock markets and profiting at the expense of traditional market players.

Regulators need to find a balanced approach of checks and balances to weed out the ‘bad’ HFT from the ‘beneficial’.

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