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High Frequency Trading - is trading technology moving too fast for markets?
In light of the arrest on 21 April of a London based independent trader on charges issued by US authorities in relation to the 2010 “Flash Crash”, questions arise as to just what is high frequency trading (‘HFT’) and what is being done to regulate it?
What is HFT?
HFT is a legitimate trading strategy that is generally viewed as a subset of algorithmic trading. It operates in practice where a trading system analyses data or signals from the market at high speed and then sends or updates large numbers of orders, quotes and cancellations within a very short time period in response to that analysis.
One feature of this type of trading is that it can operate with no human input to the decision making process, beyond setting certain parameters of an underlying algorithm. Other characteristics of HFT include a short time-frame for establishing and liquidating positions, high daily portfolio turnover and a high intraday order-to-trade ratio.
HFT is often utilised by traders using their own capital to trade and rather than being a particular strategy in itself, is usually just the use of sophisticated technology to implement more traditional trading strategies such as market making or arbitrage.
'The May 2010 Flash Crash'
On 6 May 2010 the prices of many US-based equity products experienced an extraordinarily rapid decline and recovery. The Security and Exchange Commission’s (‘SEC’) report, produced in the aftermath of the crash, concluded that the crash commenced with a large mutual fund initiating a sell programme of $4.1bn in order to hedge an existing equity position they were holding. This sell programme was issued via an automated execution algorithm. Due to the way this sell algorithm was programmed the trades were executed in only 20 minutes. In the past the mutual fund had conducted such sell programmes over a period of hours. Under the stressed market conditions, the automated execution of the large sell order triggered extreme price movements because of the way the sell program algorithm and HFT algorithms interacted, resulting in an erosion of liquidity and disorderly markets. The Dow Jones Industrial Average saw 9% wiped off its value followed by an almost as dramatic and immediate recovery. This was a stark wake up call for regulators as to the risk that had been created by this new reliance on ‘automated trading technology’ and the risks involved with malfunctions and potential abuse.
The impact of MiFID II
In Europe, Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments (‘MiFID II’) entered into force on 2 July 2014 and will apply from 3 January 2017. Part of MiFID II seeks to introduce rules and guidelines to mitigate against flash crashes caused and exacerbated by automated trading technology and HFT.
MiFID II seeks to ensure orderly and fair trading conditions for all market participants through a broad range of measures. Through the implementation of MiFID II, the European Commission (‘Commission’) seeks to, recognise the benefits of the advances in trading technology to the market and market participants, such as, wider participation in markets, increased liquidity, narrower spreads and the means to obtain better execution of orders for clients.
However, MiFID II also highlights some issues arguably created by these advances, such as the increased risk of overloading trading venue’s systems and the risk of algorithmic trading generating erroneous orders or otherwise malfunctioning in a way that may create a disorderly market. In order to counter these potential issues MiFID II imposes a number of new requirements.
New requirements for HFT firms
MiFID II will require an HFT firm that pursues a “market making strategy” to:
- carry on its market making activity continuously during a specified proportion of the trading venue’s trading day, except under exceptional circumstances;
- enter into a written agreement with the trading venue stating their market making obligations; and
- have in place effective systems and controls to ensure that it fulfils its obligations under the agreement.
A firm will be deemed to be pursuing a “market making strategy” where as a member of a trading venue its strategy when dealing on its own account involves:
- posting firm, simultaneous two way quotes of comparable size and at competitive prices,
- that relate to one or more financial instruments,
- on single or multiple trading venues,
- on a regular and frequent basis.
ESMA will submit final regulatory technical standards to the Commission by mid-2015 and these will further specify, among other things, the minimum obligations to be specified in a market making agreement (including the specified proportion of the trading venue’s trading day) and the exceptional circumstances when quotes need not be shown.
MiFID II dictates that most firms that engage in a HFT strategy will have to become regulated by their national competent authority. In the UK this will be the Financial Conduct Authority (‘FCA’).
HFT firms will be further required to store time records in relation to their use of algorithms in their trading operations for an extended period. The European Securities and Markets Authority (‘ESMA’) has suggested that HFT firms should keep accurate and time sequenced records of all its placed orders, including cancellations of orders, executed orders and quotations on trading venues, details of algorithms and all key compliance and risk controls. These details should be made available to the national competent authority upon request and should be held for a period of 5 years.
New requirements for trading venues
Regulated markets and trading venues will have to introduce and implement robust measures in order to ensure that HFT techniques do not create a disorderly market or are used in a way that facilitates market abuse. Trading venues will need to ensure their systems are resilient and properly tested to deal with increased order flows or market stresses.
Trading venues will also be required to install ‘circuit breakers’ into their systems so that they can temporarily halt trading or constrain it if there are sudden unexpected price movements. A tick size regime in financial instruments will also have to be introduced and calibrated to reflect the liquidity profile of the financial instrument and the average bid-ask spread. It will be down to each Member State to balance the desirability of stabilising prices with the need to avoid narrowing spreads too far.
Under MiFID II, all orders HFT orders generated by an algorithm will have to be flagged. This will allow competent authorities, such as the FCA, to identify and distinguish orders originating from different algorithms and to further understand the strategies that HFT traders employ.
In a further measure to dissuade some forms of HFT strategies, trading venues will be allowed to adjust their fees for cancelled orders according to the length of time for which the order was maintained and to calibrate those fees to specific financial instruments.
MiFID II has tasked ESMA with regularly seeking views from national experts on developments relating to trading technology and new practices that could constitute a form of market abuse. It is hoped that through this dialogue, ESMA will be better able stay up to date with technical developments within the various markets and the impact of incidents such as the 2010 flash crash can be in some way lessened.
The future for HFT
The electronic trading sector has been inundated with regulation since technological advancements were first applied in this area. These advancements have helped the sector achieve exponential growth and regulators have now been tasked with the difficult task of protecting the integrity of the market while not stifling innovation.
MiFID II will bring significant changes to this area and it is not yet clear as to how HFT firms will adapt. What is clear, however, is the need for all market participants to remain up to date with technological change.
To discuss any of the matters raised above please contact the Financial Regulatory team at Kemp Little.