Market surveillance systems provider RedKite has said that new guidelines from the European Securities Markets Authority (ESMA) on automated trading could affect between 80-90% of order flow, forcing many firms to increase their investment in real-time market surveillance equipment.
On 20 July 2011, ESMA, the pan-European securities regulator, issued a consultation paper titled ”Guidelines on systems and controls in a highly automated trading environment for trading platforms, investment firms and competent authorities'.
The paper consults on draft ESMA guidelines, which are intended to reduce the potential for market abuse and manipulation, and will complement the upcoming MiFID II and market abuse directive proposals. The guidelines cover all providers of direct and sponsored access, algorithmic trading, prop trading firms as well as any firms that are members of execution venues, execute orders automatically, or allow clients to execute orders without intervention.
The guidelines state that investment firms should ensure their compliance staff have a feed of their orders that is delivered as close to real time as possible and have systems for monitoring those orders. They also suggest that firms providing direct access to trading venues should provide a real-time feed of orders and executions that separately identifies different clients as well as the firm's own proprietary trades.
“The implication of these proposals are huge,” said Mathew Coupe, director of sales and marketing at RedKite. “Anyone with an exchange membership, who is providing direct market access, sponsored access, or any kind of automated trading activity onto the market, will have to have risk controls and a real-time data feed of transaction information connected directly into the compliance department.”
High-frequency prop trading firms will be particularly affected, added Coupe, since they will need to introduce pre-trade risk controls on their own order flow – a measure they currently are not necessarily obliged to take because the current rules only apply to trading venues and brokers providing sponsored access, thus creating an effective loophole for firms that only trade using their own capital. It is a timely move, he argues, since real-time surveillance is the only way to gain a proper understanding of the sentiment behind rapidly-moving flows.
Faster and more sophisticated awareness also allows for the mitigation of market abuse by predatory traders before it causes significant damage. “If there's insider trading happening, you want to recognise that very quickly,” said Coupe. “You need a real-time flow of data going to the back-office compliance staff – T+1 information is no longer good enough.”
Without real-time monitoring, sponsored clients, i.e. traders that access markets directly via their broker's membership, could, for instance, use two different brokers to act as the conduit for a pair of strategies that interact with each other to gain an advantage from the market. For instance, a high-frequency trading strategy based on entering orders designed to trigger a particular market sentiment, could then be
”cashed in'.
“An abusive trader could trigger sell activity on the market, go short on that, and take advantage of the price movement, then when it regains, come out of the position,” said Coupe. “That strategy could be easily split up between two member IDs – and without adequate surveillance and market transparency, nobody else would realise.”
Fear of predatory high-frequency trading strategies taking advantage of long-term investors has often been cited as an incentive for shifting trading onto dark or over-the-counter markets. However the ESMA initiative may yet boost investor confidence that the markets are safe – an important consideration, in view of the current low equity trading volumes in Europe and especially North America.
“It's a very good start in re-assuring the market that the due diligence and process is in place,” said Coupe. “ESMA is asking every firm to document any kind of automated trading strategies and justify them.”