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This will result in changes for all types of investment managers and advisors. Algorithmic and HFT have grown to sizeable proportions in recent years. Regulators are increasingly willing and able to pursue algorithmic traders who manipulate the prices of financial instruments.
It should be noted from the outset that MiFID II does not seek to prohibit either algorithmic trading or HFT; indeed within the recitals, MiFID II extols the benefits of improved trading technology, such as wider participation in markets, increased liquidity, narrower spreads, reduced short term volatility and the means to obtain better execution of orders for clients. However, in the same breath, it acknowledges that such strategies, particularly of the HFT variety, give rise to a range of potential risks that could lead to disorderly markets or be used for abusive purposes.
The measures set out within MiFID II seek to regulate these risks through a variety of means but first we turn to who will be caught by these specific provisions. Who is in scope? Algorithmic trading firms are defined under MiFID II 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.
Systems are considered to have no or limited human intervention where, for any order or quote generation process or any process to optimise order-execution, an automated system makes decisions at any of the initiating, generating or routing stages or executing orders or quotes according to pre-determined parameters. For the purposes of MiFID II, HFT is considered to be a subset of algorithmic trading and thus subject to the same requirements and controls and is defined by the following characteristics:.
This is a significant change for proprietary traders who have, up until this point, largely been able to eschew regulatory supervision.
High frequency traders will additionally be required to record accurate and time sequenced details of each submitted order, including cancelled orders, executed orders and quotations on trading venues for a minimum of five years from the date of submission and must make these records available to the FCA upon request. Additionally, if a firm decides to outsource software or hardware used in its algorithmic trading activities, it will still have to retain sufficient knowledge of the outsourced systems and maintain appropriate documentation regarding the outsourced software or hardware for the purposes of regulatory responsibility in the event that the regulator has questions surrounding the outsourced functions.
Algorithmic traders will be required under MiFID II to have effective systems and controls to ensure that their trading systems:. When material changes are made to the algorithmic software, firms must ensure that the time of change, author, approver and nature of the change are recorded. Additionally, before algorithmic systems are deployed, firms must set limits on the number of instruments traded, the price, value and numbers of orders, the strategy positions, and the number of trading venues to which orders are sent, to ensure they maintain control over the process.
Conformance tests with trading venues, where an algorithmic trader trades as a member or through sponsored access, and DMA providers will be required to ensure that the basic elements of the system or algorithm operate correctly and in accordance with the requirements of the trading venue or DMA provider. In addition to specific market abuse monitoring, firms will be 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 done by the trader responsible for the algorithm and must be supported by an independent risk control function. Monitoring systems are required to have real-time alerts to assist staff in identifying any unanticipated activities undertaken by an algorithm and a process should be in place to take remedial action as soon as possible after an alert is generated, including, where necessary, an orderly withdrawal from the market.
Firms will be required to implement pre- and post-trade controls, the former with the aim to prevent overly risky or erroneous orders from reaching the market and the latter attempting to ensure that algorithmic systems can be adjusted or shut down as quickly as possible where risk thresholds are breached.
The pre-trade controls should include price collars, maximum order value, maximum order volume and maximum messages limits. All orders sent should immediately be factored into the pre-trade risk limits. From a post-trade control standpoint, firms should continuously monitor credit risk and market risk exposures and reconcile internal records against those of external service providers including trading venues and brokers.
Although the scope of this operation would depend on the nature, scale, and complexity of the business, firms with algorithmic strategies must undertake an annual self-assessment and validation process of the algorithms and trading systems, governance arrangements, business continuity arrangements, and compliance with MiFID II.
ESMA has released a list of items which algorithmic firms should consider as part of this self-assessment process which we envisage making up part of the compliance monitoring programme.
A validation report should be created by the risk management function following the self-assessment process, with formal approval from senior management and any issues identified being flagged to Compliance.
As noted above, MAR brought in the requirement for firms arranging or executing orders to maintain appropriate arrangements, systems and procedures for preventing, detecting and reporting abusive practices and suspicious orders and transactions.
Firms must document such arrangements, and provide these to regulators on request. Algorithmic traders who carry out market making activities will be required under MiFID II to do so continuously during a specified number of hours while a trading venue is open so as to provide liquidity. Such firms will be required to enter into written agreements with relevant trading venues to confirm this. As the market making requirements only apply to firms who deal on their own account, these provisions are less likely to apply to our clients but they do represent a significant change for algorithmic traders in the industry.
We are mindful that there is a lot to digest when it comes to MiFID II, and the additional compliance obligations for algorithmic traders adds an onerous new layer of regulation for such firms.
Skip to main content. Home About Why use us? For the purposes of MiFID II, HFT is considered to be a subset of algorithmic trading and thus subject to the same requirements and controls and is defined by the following characteristics: Beyond notification, the regulator may also request to be provided with a description of the strategies a firm employs, key compliance and risks controls, and trading limits.
This means having access to those in the firm who have a detailed technical understanding of the underlying algorithms and systems. In practice this will mean not only having written policies to allow the firm to demonstrate that appropriate arrangements are in place, but also ensuring that the technical aspects of the algorithm and its interface with the market are free of glitches and faults which would otherwise render the firm in breach of its regulatory obligations.
MAR made clear that some level of automation was the preferred option in the surveillance process and we feel that this is especially relevant to firms with algorithmic and HFT strategies. It sets out that surveillance systems for these firms must generate alerts of potentially abusive conduct by the beginning of the following trading day or at the end of the following trading day — the latter if manual processes are used as part of the monitoring process.
An annual review of these market abuse monitoring systems must be completed to ensure they meet regulatory obligations and weed out false positives and false negatives. Annual self-assessment and validation Although the scope of this operation would depend on the nature, scale, and complexity of the business, firms with algorithmic strategies must undertake an annual self-assessment and validation process of the algorithms and trading systems, governance arrangements, business continuity arrangements, and compliance with MiFID II.
What else should I be aware of? Obligations stemming from the MAR As noted above, MAR brought in the requirement for firms arranging or executing orders to maintain appropriate arrangements, systems and procedures for preventing, detecting and reporting abusive practices and suspicious orders and transactions.
Market making RTS 8 Algorithmic traders who carry out market making activities will be required under MiFID II to do so continuously during a specified number of hours while a trading venue is open so as to provide liquidity. The same applies to clearing members. Although the obligation falls on the trading venue to set the ratio and observe its fulfilment, it affects HFTs who will have to monitor their OTR to make sure it is under the limit. A tick size is the smallest increment of trading allowed on a venue, and ESMA makes clear that this should be determined according to the liquidity profile of the instrument traded as well as the price of the submitted order.
ESMA has set out component pieces to determining these tick sizes. What should I do next? To make this process a bit easier, we have set out the critical actions that we feel will help firms best prepare: A gap analysis should be undertaken against current processes to identify where updates will be required. Maintain logs on the algorithms, risk controls, alterations to any systems, and granular detail on transactions. Subscribe Sign up today for ACA newsletters, alerts, and event notifications.
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