The latest agreements reached in negotiations for MiFID II will require firms to have their algorithms authorised by regulators and tested, but market participants are doubtful the plans will succeed.
Markus Ferber MEP, who is representing the European Parliament in trialogue discussions to reach an agreement between the European Parliament and European Council on MiFID II’s final text, has announced a major breakthrough on some aspects of the legislation.
According to Ferber, the parties have agreed to introduce a minimum tick-size to limit high-frequency trading (HFT), testing and regulatory authorisation of algorithms and introducing circuit breakers on venues.
“Currently, the area of high-frequency trading is lacking suitable regulation. This is why it was high time to find a decent solution to this pressing problem. Hence, I am very happy that during the trialogue session last Wednesday, the negotiation team achieved a significant breakthrough on this issue,” Ferber told theTRADEnews.com.
However, there remain doubts about whether regulators are equipped to properly analyse and understand many of the complex algorithms currently available.
“Understanding algorithms is challenging and I think it’s very unlikely that regulators will have the resources to get to grips with them,” said Rob Boardman, CEO of EMEA at agency broker ITG.
While Boardman thinks full authorisation of algos by regulators is unlikely, brokers creating algos will probably be required to produce more documentation on how their algorithms are developed and operated.
“Brokers are going to have to manage their algorithms better because regulators want to avoid having another rogue algorithm disrupting markets, or algorithms which are abusing markets,” he explained.
BATS Chi-X CEO, Mark Hemsley, thinks it is unlikely that exchanges will be able to shoulder the regulator’s burden to authorise algos.
“As part of our ‘know your customer’ process and our market surveillance role we will understand and monitor how customers use algos, but unless there is a radical change in the way exchanges are resourced then it’s not realistic for us to be able to verify individual algos on an on-going basis,” he said.
Mandatory testing of algorithms also risks harming competition in the market, according to Robert Stowsky, senior analyst at consultancy Aite Group.
He said: “If regulators lack the resources to analyse these algorithms and we end up with a lengthy process to bring an algo to market, then we’ll see much simpler, 'vanilla' algorithms being developed to ensure they can get past the regulators more quickly.”
Lack of clarity
Meanwhile, the minimum tick-size rule, which would reduce pricing granularity and, according to Ferber, slow markets down and reduce systemic risks to market, is seen by some as underwhelming.
Hugh Cumberland, financial services solutions manager at technology provider Colt, said: “If you really wanted to stop HFT, then you would introduce a financial transaction tax, but you’d also kill your capital markets as has happened in France and Italy. Minimum tick-size, order resting limits and other suggestions in MiFID might slow markets down a little, but I doubt they will have a big effect of HFT firms and could have unintended consequences for the rest of the market.”
Stowsky criticised the latest announcement for failing to provide clarity on other aspects of rules to curb HFT.
“We have confirmation that there will be a minimum tick-size,” he said, “but we’re still waiting to find out if there will be a minimum resting time for orders or charges for cancelled orders. These are big issues and the market needs assurances on this as soon as possible.”
Hemsley said what the industry really needs more clarity on how regulators will be expected implement these rules.
“The devil is in the detail and the key objective should be to encourage overall liquidity. While a minimum tick-size might seem simple, setting an appropriate tick-size really depends on the individual stock. Some of the less liquid stocks might benefit from a bigger tick, for example,” he explained.
Different rules might also be required for IPOs, with tick sizes reviewed more regularly than other stocks until an appropriate size for that stock is found.
Despite concerns, Ferber believes the latest agreements are major milestones, which should enable trialogue discussions to be concluded soon.
“This set of new rules will contribute to financial markets in Europe that will work more efficiently and more safely. Apart from that, the deal struck on Wednesday is a significant step towards reaching a common agreement on MiFID II by the end of the year,” he said.
With European Parliament elections due to take place in May 2014, MEPs and the European Council have been scrambling to reach agreement on key legislation, including MiFID and the European market infrastructure regulation, before the Parliament breaks up to begin campaigning.