How does the European Commission propose to regulate automated and high-frequency trading in its MiFID II consultation?
On 8 December 2010, the European Commission (EC) started its consultation phase for the MiFID review. The consultation paper includes a section dedicated to how the existing regulatory framework for Europe's securities markets should be adapted to account for the growth in automated trading and related issues.
It suggests a broad definition for automated trading, with a sub-category for high-frequency trading included under this umbrella. An automated trader would be defined as any participant that uses algorithms “to determine any or all aspects of the execution of the trade, including timing, quantity and price”. While automated trading is often considered to involve automation of both the investment decision, i.e. the buy / sell signal, and its execution, the definition offered by the EC would appear to cover any use of a broker-supplied execution algorithm by a buy-side firm.
The EC has also proposed technical risk management standards to prevent system errors and monitor sponsored access arrangements. It sparked alarm in some quarters by calling for market participants to notify authorities of the algorithms they use. At the moment, some market participants provide high-level information on their algorithms to trading venues, but this is not mandated.
In addition, all markets could be required by MiFID II to have their own circuit breakers in place – to give venues their own risk controls for managing automated trading – stress test their platforms for resilience, and offer fair and equal access to co-location services.
The European Securities and Markets Authority, the pan-European securities regulator that took over from the Committee of European Securities Regulators (CESR) at the start of this year, could also be given authority to set standards on tick sizes and circuit breakers under the EC proposals, adding another layer of potential controls for automated trading at the regulatory level.
Responses to the consultation are due in by 2 February.
Why does the EC feel tighter controls are necessary?
The potential regulatory implications of growing levels of high-frequency trading and other market innovations in Europe were first raised by CESR in a consultation undertaken in April 2010. CESR sought to assess the impact of technology-enabled trading practices and processes on equity market efficiency by collecting evidence on high-frequency trading, co-location, fee structures and indications of interest.
The EC's current MiFID consultation notes that while high-frequency trading can add short-term liquidity to the market, liquidity quality and transaction size may have been negatively affected. The EC also raised concerns about the potential threats that automated trading poses to orderly markets, from rogue algorithms to the increased capacity pressure on trading venue systems to process larger number of orders.
How will high-frequency traders be regulated under the new proposals
High-frequency traders will be classified as a subset of the automated trading category laid out in the MiFID II consultation.
The EC has raised concerns that some firms that engage in high-frequency trading are not regulated by competent national authorities or MiFID at all. Automated and high-frequency traders are private entities that deal on the markets with their own money. As non-investment firms they are not bound by MiFID. However, the EC proposes that under MiFID II any high-frequency firm that trades above a certain volume will be regarded as type of investment firm, and as such subject to the regulation's strictures on systems and risk management obligations and capital requirements, despite the fact it may have no external investors.
Perhaps with the disappearance of liquidity that accompanied 6 May flash crash in the US, the EC is also proposing trading venues ensure that high-frequency traders supply liquidity on an ongoing basis, via rules similar to those currently in place for market makers. High-frequency firms could also be required to ensure that trades rest on an order book for a minimum period before they are cancelled or that the ratio of orders to transactions executed does not exceed a specific level.
When can we expect new rules to be enforced?
The EC is due to publish responses to its consultation by mid-February. The commission aims to produce draft legislation in the summer, which will pass through the European Parliament and European Council before it is adopted into law by 2013.
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