European Commission reforms to the Markets in Financial Instruments Directive (MiFID II) represent an outright attack on high-frequency trading (HFT), but all users of algorithmic trading strategies in Europe could suffer, according to a leading law firm.
Noting that the US flash crash of May 2010 had heightened regulators’ systemic risk concerns, Philip Morgan, a partner in London-based K&L Gates’ investment management practice, said the Commission’s failure to accurately define HFT in MiFID II would have significant ramifications for all market participants using algorithms to execute equities orders.
“There is no definition of HFT but they do define algorithmic trading,” said Morgan. “This definition will be hard fought and we have already had discussions over whether or not the Commission’s definition makes sense and whether firms are able to accurately figure out if they are inside or outside the definition.”
The Commission said its proposals aim to bring all entities engaged in HFT within the existing MiFID regulatory framework, requiring the “appropriate organisational safeguards” from these firms and those offering market access to high-frequency traders. It requires venues to adopt appropriate risk controls to mitigate disorderly trading and ensure the resiliency of their platforms.
MiFID II defines algorithmic trading as when “a computer algorithm automatically determines aspects of an order with minimal or no human intervention”. The directive, issued by the Commission last month, goes on to define HFT as a specific subset of algorithmic trading where a trading system analyses data or signals from the market at high speed and then sends or updates large numbers of orders within a very short time period in response to that analysis. The EC also observes that HFT is typically done by the traders using their own capital and, rather than being a strategy in itself, is usually deploys sophisticated technology to implement existing strategies such as market making or statistical arbitrage.
The directive warns that HFT heightens several risks to the stability of financial markets including “the overloading of the systems of trading venues”, “duplicative or erroneous orders … that may create a disorderly market”, and “the risk of algorithmic trading systems overreacting to other market events which can exacerbate volatility”.
An unfair comparison?
But categorising all algorithmic trading alongside HFT is seen by Morgan – and many industry experts – as an impractical and prejudicial proposition.
“One aspect of this approach which could cause potential concern is MiFID II’s requirement that any investment firm engaged in algorithmic trading will have to act as a quasi-market maker and provide liquidity on regular ongoing basis,” said Morgan. “This doesn’t entirely make sense in all situations. For some firms engaged in algorithmic trading, this will not be appropriate.”
Martin Cornish, a partner in K&L Gates’ London office, agreed MiFID’s approach to algorithmic trading has implications for many firms and their use of electronic trading.
“Anyone using an algorithm will have to operate as a market maker, and we will see push back from industry on this issue,” said Cornish. “While there has always been a fine line between whether some firms’ systems are – or are not – market making, forcing firms and their algorithms to be in the market all the time is very different to current practice.”
Both Morgan and Cornish believe the current draft – and its definitions of algorithmic trading and HFT – is only the Commission’s “opening negotiation point”.
“We foresee HFT is where some of the most vigorous debate will be over the next year,” said Cornish. “As it is currently drafted, the definition is very simplistic and sweeps up a lot of activity.”
HFT is also subject to greater regulatory scrutiny and limitations on a national level, with France considering a tax designed to curb the practice.
The proposal, adopted by the Senate’s finance committee last week, would impose a 0.1% tax on firms that cancel more than 50% per day of their automated orders sent to exchange. The Senate described HFT liquidity as “phantom” and “artificial”, adding HFT is potentially damaging for financial markets and may push investors to trade away from exchanges.
Kee-Meng Tan, managing director and head of agency broker Knight Capital’s trading group in Europe, said he expects the proposal to fail a vote later this week.
“Any ‘evidence’ that HFT is bad for markets is only anecdotal,” Tan said. “Comprehensive academic studies including those by IOSCO and the UK Treasury’s Foresight project have not supported this notion.”
If successful, Tan suggested NYSE Euronext’s Paris bourse could suffer from losses in market share. “I am concerned that a proposal like this could damage liquidity, especially considering the already fragile state of European volumes,” Tan said.
He added that the proposed rule could catch a significant proportion of firms, including institutional investors, that used algorithmic trading strategies rather than HFT, thus undermining its stated aim.
In the US, a detailed definition of HFT has been proposed by Scott O’Malia, a commissioner at regulator the Commodity Futures Trading Commission (CFTC).
“Before we can recommend rules for HFTs, the CFTC must develop a precise and reasoned definition of who is and who is not an HFT,” said O’Malia in a letter to the CFTC’s technology advisory committee. “The CFTC needs to collect reliable data so it can define their trading activity before imposing regulations,” he said.
O’Malia outlined six criteria for establishing HFT activity, including the use of high-speed order systems with speeds in excess of five milliseconds, and the use of co-location services, direct market access and latency minimisation.
Another key identifier of HFT was the use of algorithms for automated decision-making where order initiation, generation, routing and execution were determined by a system without human direction for each individual trade or order. HFT was also characterised by high daily portfolio turnover and/or a high order to trade ratio, as well as the submission of numerous orders that are cancelled immediately or within milliseconds. Finally, O’Malia noted that high-frequency traders typically ended the day in as close to a flat position as possible.
Additional reporting: Elliott Holley