So MiFID II will regulate high-frequency trading (HFT) firms. Is the European Commission going to turn them into responsible citizens?
Possibly, but the EC's consultation document is so vague on HFT it's hard to be sure.
Because many HFT firms neither have a broker-dealer licence nor handle other people's money, they are not currently regulated under MiFID. With research consultancy TABB Group estimating that HFT will account for 40% of European liquidity this year, the EC was always likely to widen MiFID's scope to include low-latency traders.
Under its current proposals, high-frequency traders will be categorised as a subset of automated trading firms, defined extremely broadly as any market participant that uses algorithms to determine any of a trade, including the timing, quantity or price of an order.
However, the EC does not present a clear definition of high-frequency trading itself and does not differentiate between the diverse strategies that commonly fall under the HFT umbrella, such electronic market makers and stat-arb players.
The lack of distinction between types of high-frequency firms is surprising given a previous consultation by the Committee of European Securities Regulators – the pan-European securities regulatory body that was superseded by the European Securities and Markets Authority in January – which focused entirely on analysing the impact of technology-enabled trading innovations, including HFT.
Presuming the EC can define HFT firms, how are they going to reform them?
It seems that Brussels want to impose old-fashioned market making responsibilities on them. In the MiFID II consultation document, the EC proposes that exchanges should “ensure that if a high-frequency trader executes trades … on the market, then it would continue providing liquidity in that financial instrument on an ongoing basis subject to similar conditions that apply to market makers”.
But it's difficult at this stage to ascertain what these conditions might be, especially as there are no mandated obligations for market makers on most order-driven markets that use the continuous trading model. There is no mention of how market making obligations would be defined or what incentives HFTs will have for supplying liquidity in the EC consultation. This does not bode well with firms that may have to take an increased amount of risk for no benefit to themselves.
Moreover, placing market-making obligations on all HFT firms, i.e. including those stat-arb players whose strategies are not focused on supplying liquidity, could undermine the viability of their trading strategies.
Aren't the trading venues offering enough incentives to supply liquidity already?
Most multilateral trading facilities (MTFs) – including Chi-X Europe, BATS Europe and Turquoise – encourage liquidity provision by employing maker-taker pricing, which awards passive liquidity providers a rebate, while charging aggressive liquidity takers a fee.
The challenge of course, is to find a way of getting firms to supply liquidity in all market conditions.
On 1 March 2011, NYSE Euronext will launch a supplemental liquidity provider (SLP) scheme for French and Dutch blue-chip stocks for firms that trade using proprietary capital, i.e. HFT firms. Under the scheme, selected firms would have to supply liquidity in a pre-selected basket of stocks at the best bid and offer for 95% of a continuous trading period. In return, the trading firm would receive a favourable tariff on SLP-designated stocks.
The EC may be planning to impose obligations similar to NYSE Euronext, but this is by no means clear at present.
What exactly does the EC want to achieve?
By placing HFTs under an obligation to supply liquidity continuously, the EC hopes to avoid a European repeat of last May's flash crash, where on 6 May, a huge algo order initiated a sudden and sharp drop in US stock prices. The decline was widely view as being exacerbated by the behaviour of electronic market makers, who widened their quote spreads and offered reduced liquidity, with some exiting the market completely.
If this chunk of European trading volume suddenly evaporated, like it did in the flash crash, it could cause a serious systemic risk.
Is it just Europe that is considering this issue?
No. Markets across the world are considering the optimal way of controlling HFT activity.
In the US, three of the largest electronic market makers – GETCO, Knight Capital and Virtu Financial – suggested a number of responsibilities for firms that provide two-sided markets. The proposals, which are currently under consideration by regulators, include a requirement for market makers to quote inside the spread for a minimum period during market hours and have quoting size requirements based on the price and average daily value traded of a stock. This will ensure that the liquidity provided by market makers is not too thin and offered at a reasonable price.
In Asia, the Australian Securities and Investment Commission asked market participants in a recent consultation whether there should be formal obligations on electronic liquidity providers to help maintain orderly trading conditions.
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