MiFID II – The End of Algorithmic Trading?
In the last decade, Algorithmic Trading and High-Frequency Trading (HFT) have come to dominate the trading world. Between 2004 and 2014, this form of trading increased tenfold, accounting for over 60% of global trading at its peak. However, in the last few years these strategies have also taken a lot of criticism, causing the ‘Flash Crash’ of May 2010 and the greatest fall in the Dow in decades. Such events have resulted in calls for increased regulation and surveillance on Algorithmic Trading and HFT.
While advancements in technology have allowed Algorithmic and HFT traders to move ahead with order books that allow them access to liquidity spread across markets, surveillance and compliance teams cannot seem to catch up. One legislation that is attempting to tackle the risks involved with Algorithmic Trading and HFT is the Markets in Financial Instruments Directive (MiFID). MiFID is one of the cornerstones of EU financial services law setting out which investment services and activities should be licensed across the EU and the organisational and conduct standards that those providing such services should comply with. On 3rd January 2018, the revised Markets in Financial Instruments Directive (MiFID II) is expected to come into force, replacing the existing MiFID, and one of the main areas that this new regulation will address will be in Algorithmic Trading and HFT.
But what are the main issues with surveillance on Algorithmic Trading and HFT, and can MiFID II solve them?
MiFID II defines Algorithmic Trading firms as those who use a computer algorithm which automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order, with limited or no human intervention. A cause for concern with automatic trading is the increased risk of market manipulation, which may manifest itself in many ways, such as:
Electronic Front Running
Slow Market Arbitrage
“Quote Stuffing” involves quickly entering and withdrawing a large number of orders in an attempt to flood the market. This can create confusion in the market and trading opportunities for high-speed algorithmic traders. MiFID II has introduced a maximum order to trade ratio in an attempt to reduce risk from this form of manipulation.
“Spoofing” is the process of placing limit orders outside the current bid and ask levels to change the reported price to other market participants. The trader can then place trades based on that artificial change in the price and then remove the spoofing orders before they can be executed. MiFID II is tackling this issue by ensuring Algorithmic and HFT traders have appropriate trading thresholds and limits. Appropriate systems and controls must be in place to prevent any orders that could contribute to a disorderly market. Along with this, MiFID II requires these strategies to go through numerous testing programmes to monitor the design and performance of the systems to ensure they are free of any faults or glitches and to reduce the risk involved in using these systems.
“Electronic Front Running” involves using extremely fast computer programs to detect market orders and to trade ahead of them. This could result in the trader with the original order having to buy at a higher price.
“Slow Market Arbitrage” is when the price of a stock changes on one stock exchange and the HFT algorithm picks up orders available on other exchanges before they have had a chance to react. Although there are currently some methods of trying to investigate these forms of market abuse, MiFID II’s “Market Abuse Monitoring” has taken this a step further. It mandates that surveillance systems for these firms must generate alerts of potentially abusive conduct by the beginning of the following trading day. An annual review of these market abuse monitoring systems must be completed to ensure they meet regulatory obligations and reduce any false positives. Alongside the Market Abuse Monitoring, firms are required to monitor all orders sent to trading venues in real-time with the aim of detecting signs of disorderly trading. Real-time monitoring must be performed by the trader responsible for the algorithm and this must be supported by a risk control function. MiFID II firms with algorithmic strategies must additionally have effective business continuity arrangements to deal with disruptive incidents as well as mechanisms to control trading. They must be able to detect any negative impacts algorithms might have, and to be able to be able to cancel all outstanding orders at all trading venues by means of a “kill button”.
Does MiFID II solve the surveillance issues with Algorithmic Trading and HFT?
Surveillance of Algorithmic Trading and HFT is, and will remain, a major issue for the regulators. Effective surveillance is extremely difficult due to the advancements in technology in the past decade in how trades are executed. With all of this in mind, we cannot say definitively that MiFID II will solve all of the issues involved with Algorithmic Trading and HFT, but it is clear that it has taken a huge step in the right direction. Increased regulatory scrutiny and surveillance comes at a financial cost in an era where institutions are looking to cut expenditure. As a result, many banks have made the decision to outsource their surveillance functions/programmes in a bid to lower costs. FinTrU’s near-shore offering enables us to provide analysts that are experienced in Trade Surveillance, Compliance and Regulatory Reporting, within the UK and European regulatory landscape, delivering a professional, cost-effective service to our clients.
Michael joined FinTrU in 2015 through our second Financial Services Academy. He has since worked as a Trade Surveillance and Compliance analyst for a Tier 1 investment bank.
Michael graduated from Queens University Belfast with a BA (Hons) in Economics and Accounting and joined FinTrU to expand his knowledge in the financial services sector.
Within his current role as part of the Trade Surveillance team, Michael is responsible for surveillance within the Equities and Fixed Income markets for both EMEA and APAC. He conducts investigations into possible cases of market abuse or insider trading through analysing trading patterns, market events and electronic communications surveillance.