Malta Algorithmic Trading: The New MiFID Regime

Dr. Maria Chetcuti Cauchi | Published on 21 aug. 2014 | Updated on 01 aug. 2018

Malta Algorithmic Trading The New MiFID Regime

Malta Algorithmic Trading: Definition

Algorithmic trading deals with trading in financial instruments where a computer algorithm determines individual parameters of orders with little or no human intervention. It does not include any system used only for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters. On the other hand, high-frequency algorithmic trading, a sub-category of algorithmic trading, concerns a technique characterised by:

(a) infrastructure intended to minimise network and other types of latencies, including at least one of the following facilities for algorithmic order entry: co-location, proximity hosting or high-speed direct electronic access;

(b) system-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders; and

(c) high message intraday rates which constitute orders, quotes or cancellations.

MiFID 2 focuses on the algorithmic trading activity and applies a set of regulations intended to govern this sector. 

The Impact of MiFID 2

On the 15th of April 2014, the European Parliament in plenary session adopted updated rules for markets in financial instruments, MiFID 2, Directive 2014/65/EU, which is not in force yet. MiFID 2 is expected to impact the European securities market in a profound manner. One of the sectors which will experience the impact of the directive most keenly is the Algorithmic / High-Frequency trading sector.

The Directive will introduce trading controls for algorithmic and high-frequency trading activities which have drastically increased the speed of trading. Such safeguards include the need for all algorithmic traders to be properly regulated and to provide liq

Registration Requirements for Algorithmic Traders

MiFID 2 will have a number of implications for algorithmic trading. First and foremost, algorithmic traders will need to be registered as an investment firm. Previously algorithmic traders could benefit from an exemption from registration requirements if they were only ‘dealing on own account’, that is, only putting their own proprietary capital at risk. This will no longer be possible under MiFID 2 and all algorithmic trading firms will need to be registered and will be subject to regulation as investment firms. This will bring regulatory scrutiny to such firms, as well as the obligations and burdens associated with regulated financial businesses, such as reporting to financial services authorities.

Organisational Requirements

The investment firm is to ensure that it complies with the applicable obligations under MiFID and other relevant EU and national laws. The compliance staff should be responsible for providing clarity about the firm’s regulatory obligations and the policies that seek to ensure the use of algorithms complies with the firm’s obligations and that any failures to comply are detected.

MiFID 2 requires that algorithmic trading firms provide annual reports to regulators providing that there are proper risk controls. Investment firms should make use of development and testing methodologies before setting up a trading algorithm. The use of these methodologies should seek to ensure that the operation of the trading algorithm is compatible with the investment firm’s obligations under the relevant legislation.

An investment firm that engages in algorithmic trading in a Member State shall notify this to the competent authority of its home Member State and of the trading venue at which it engages in algorithmic trading. The national competent authority may require the investment firm to provide, on a regular or ad-hoc basis, a description of the nature of its algorithmic trading strategies.

Member States shall require a regulated market to have effective systems and procedures, including requiring participants to carry out appropriate testing of algorithms to ensure that algorithmic trading systems cannot create or contribute to disorderly trading conditions on the market and to manage any disorderly trading conditions should they arise. The fee structure of the trading venue shall be transparent, non-discriminatory and fair and not structured in a way so as to promote disorderly market conditions or market abuse.

Risks and Algorithmic Trading

An investment firm conducting algorithmic trading shall have efficient systems and risk controls suitable to the business it operates, ensuring that its trading systems are resilient. Risks arising from algorithmic trading should be regulated and such effective systems and risk controls should serve to ensure that the trading systems cannot be used for any purpose falling foul of Regulation (EU) No 596/2014 or to the rules of a trading venue to which it is connected.

To ensure effective supervision and to enable the competent authorities to take appropriate and timely measures against defective algorithmic strategies, it is necessary to flag all orders generated by algorithmic trading. Flagging allows the competent authorities to react efficiently against algorithmic trading strategies that behave in an abusive manner or which pose risks to the orderly functioning of the market.

ESMA and Risk Controls

ESMA aims to set the minimum requirements that all investment firms should meet in relation to their trading systems directly or indirectly linked to algorithmic trading. It does recognise that the risks stemming from algorithmic trading activities are not homogenous across all firms. Thus, ESMA considered it appropriate to preserve the proportionality principle established in its guidelines, allowing market participants to adapt such requirements according to the ‘nature, scale and complexity of their business’.

ESMA indicates that investment firms themselves should ensure that their systems are fully tested and should therefore remain responsible for assessing testing results and making changes to the algorithmic trading strategy.

AFME and the European Commission

The position of the Association of Financial Markets in Europe (AFME) concerning the European Commission’s proposals to regulate high-frequency trading is that algorithms should operate in a controlled environment with strict controls. AFME suggests that The Market Abuse Directive and Regulation are appropriate to address concerns of potential market abuse involving algorithmic trading than MiFID. According to AFME, the majority of academic research has viewed the activities of high-frequency trading as improving market efficiency. In this regard, AFME has noted that the harmful effects that may arise from high-frequency and algorithmic trading are less extensive than many thought.

The Commission recognises that trading technology has provided a wide range of benefits to the market, but it has also taken into account the number of risks that are presented, namely the risk of algorithmic trading generating duplicative or erroneous orders. It has thus proposed a number of regulatory measures.

The Commission proposed that markets should manage to temporarily stop trading if there is significant price movement in a financial instrument during a short period of time. Moreover, regulated markets shall have systems allowing them to limit the ratio of unexecuted orders to transactions.

Monitoring

Investment firms engaging in algorithmic trading should monitor the activities of individuals trading on behalf of the firm and the trading activities of clients, taking account of orders submitted, modified and cancelled as well as transactions executed.

In the case of an investment firm providing direct electronic access, it shall be responsible for ensuring that the clients using that service comply with the requirements laid down in the Directive and the rules of the trading venue. The firm shall monitor the transactions to identify any infringements of those rules, disorderly trading conditions, or conduct that may involve market abuse.

ESMA indicates that a “kill-button”, which would allow investment firms to pull all outstanding orders from the market, would be required. Given the risks algorithmic trading firms are exposed to, an effective “kill-button” procedure would ensure adequate risk management and would safeguard the way in which the market functions. 

Due Diligence

The investment firm should run a validation process of all systems and algorithms and establish a report for the senior management on the basis of a respective risk assessment of the systems and algorithms at least twice annually. ESMA’s view is that not only all prospective participants of a trading venue should be subject to adequate due diligence to ensure that they meet certain pre-defined parameters, but also all its current participants.

Record-keeping

Investment firms are to retain records about the algorithms which it uses, including a description of the trading strategy it has employed. Such records must be detailed to allow the competent authority to monitor the firms’ compliance with the requirements laid down in the Directive. Investment firms should keep records of their electronic trading systems for at least five years.

In the event that an investment firm engages in a high-frequency algorithmic trading technique, it shall store accurate and time sequenced records of all its placed orders, including cancellations of orders, executed orders and quotations on trading venues. The firm shall make such records available to the competent authority upon request.

 


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