2 Fast 2 MiFID: What Does Brussels Have in Store for HFT?

The European Securities and Markets Authority (ESMA) has published the final proposed Regulatory Technical Standards (RTS) on the revised Markets in Financial Instruments Directive (MiFID II), which will go into effect January 2017. CFA Institute had previously responded to a consultation on this Directive, so it is interesting to see what, if anything, has changed since those earlier proposals.

In this blog post I will focus on the equity market structure elements of MiFID II while my colleague Rhodri Preece, CFA, has covered much of the rest in this blog post. The goals of MiFID II in regards to equity market structure are mostly to limit nontransparent trading) and strengthen controls and system resilience with regard to algorithmic and high-frequency trading (HFT).

The section on off-exchange trading focuses on recalibrating the use of pre-trade transparency waivers. Trading under the waivers (i.e., in the dark) is allowed with some qualifications. In particular, dark trading under these waivers is subject to a double-volume cap calculation so that pre-trade price transparency must be provided when:

• A given dark trading venue hosts more than 4% of the total volume of trading in that security on all trading venues over the past 12 months.
• Overall trading in the dark in a particular security is more than 8% of the total volume of trading across all trading venues over the past 12 months.

The 12 months used to calculate the double-volume cap will operate as a rolling window and ESMA will publish an updated total volume within five working days of each calendar month.

MiFID II also addresses the issue of the very broad definition of ‘over-the-counter’ (OTC) by introducing a trading obligation for shares. This restricts the ability for shares to trade in opaque off-exchange venues unless the trade is

“… non-systematic, ad-hoc, irregular and infrequent, or are technical trades such as give-up trades which do not contribute to the price discovery process. Such an exclusion from that trading obligation should not be used to circumvent the restrictions introduced on the use of the reference price waiver and the negotiated price waiver or to operate a broker crossing network or other crossing system.” [MiFIR Recital 11]

To provide more clarity for market participants, the technical standards list the types of trades that will fall under the trading obligations and those that can remain OTC. By further restricting the types of trades that can go OTC, MiFID II is directing more trading onto organised venues or systematic internalisers. In both cases the trades are then subject to the transparency waiver framework described above.

Regarding HFTs, these will now be directly regulated. One of the more controversial provisions requires firms engaged in electronic market making strategies to post firm, competitive, simultaneous two-way prices during at least 50% of daily trading hours. These obligations kick in when a firm “… posts simultaneous two-way quotes of comparable size and at competitive prices in at least one financial instrument on a single trading venue for at least 50% of the daily trading hours …”. The 50% threshold was raised from the 30% proposed in the earlier consultation after negative feedback from respondents. Given that many concerns about HFT and fragile liquidity centre on flash crashes that come and go in a matter of minutes, it will be interesting to see whether these market-making obligations will be helpful to avoid future flash crashes.

Other changes that will affect HFTs is the new time-stamping requirement whereby any reportable event must be time-stamped to a millisecond, while high-frequency traders must time-stamp to one microsecond and ensure a 100-microsecond accuracy. These changes will benefit regulators, traders, and academics most of all by making it easier to analyse historical trading more accurately. A further boon for researchers, retail investors, and smaller institutions alike are rules that require exchanges to provide unbundled data and to price their data on a ‘reasonable commercial basis’, as well as the long-awaited creation of consolidated tape providers. CFA Institute has advocated strongly for these provisions in order to boost accessibility to markets for all types of investors and to provide a consolidated view of fragmented trading activity.

HFTs will also be required to annually test their algorithms so that they behave as designed, comply with the firm’s regulatory obligations, conform to the trading venue’s rules and systems, and do not contribute to disorderly trading conditions. There is also a requirement that the algorithms be tested to ensure they work effectively in stressed market conditions and, where necessary, could be switched off. In turn, trading venues permitting algorithmic trading will also be required to perform a due diligence and conformance testing on the users of its systems. For example, venues should test their members’ algorithms to avoid disorderly trading conditions. The new tick-size regime is perhaps less newsworthy than the changes listed above, but is actually a very important measure designed to regulate HFT. Currently, European tick sizes are largely harmonised under a self-regulatory initiative led by exchanges and are a function of the price level. MiFID II extends this framework and formalises it, by basing tick size both on share price and liquidity factors to find a better compromise between the pooling of liquidity in tick-size buckets and a sufficient granularity to avoid long queues forming. The liquidity ranges determining tick sizes will be based on the average number of trades per day.

At CFA Institute, we are supportive of a tick-size regime that is, in part, based on liquidity, rather than the one-size-fits-all tick-size policy in the US. In our recent market liquidity report we posited that the US tick-size system may inadvertently increase adverse selection on lit venues by enabling electronic market makers to step in front of the lit quote during stable market conditions by offering nominal price improvement in the dark. Then, when they predict the quote is about to roll, these electronic market makers can hit standing lit-limit orders that are now on the wrong side of the trade.

With a more granular and customised tick-size policy, we think it may be more difficult for quotes to remain constant for long periods of time and the nominal price improvement strategy may therefore be less feasible. Our report did not observe the strategy described above in UK or French markets, which may be related to the EU’s more sophisticated tick-size framework.

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Image credit: iStockphoto.com/alexskopje