The Impact of MiFID 2 on Algorithmic Traders

Chetcuti Cauchi | Published on 26 Apr 2014 | Updated on 18 Feb 2016

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Malta algorithmic trading: 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. 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.

What is algorithmic trading?

Algorithmic trading is a form of trading where a computer algorithm automatically decides to place an order with little or no human intervention. High frequency trading (HFT) is a sub-category of Algorithmic trading, in which markets are analysed and orders made (again by computer programs) at very high speed. The current text of the MiFID 2 defines Algorithmic trading thus:

"Algorithmic trading" means trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention. This definition does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the confirmation of orders;

The development of these technologies has increased the speed with which investors can trade, and has enabled wider participation in markets, increased liquidity and narrower spreads. However Algorithmic trading has also given rise to a number of risks, such as an increased risk of overloading the systems of trading volumes due to the large volumes of orders, the risk of technological malfunctions distorting the market, and also new opportunities for potentially abusive behaviour.

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 a registration requirement 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.

Other key requirements

MiFID 2 will also require firms that engage in algorithmic trading to provide their competent authorities with a description of the nature of algorithmic strategies that they employ, details of the trading parameters or limits, and details of the key compliance and risk controls. This will regulators access to a significant pool of data which was previously closed to them.

Controversially, MiFID 2 also  requires the trading parameters or limits of an algorithmic trading strategy to ensure that the strategy posts firm quotes at competitive prices with the result of providing liquidity on a regular and ongoing basis to these trading venues at all times, regardless of prevailing market conditions. This may be problematic for certain traders and may lead to such operators withdrawing from markets captured by MiFID 2.

MiFID 2 also introduces the notion of ‘circuit breakers’ into European securities law. Members states must require regulated markets to have in place effective systems, procedures and arrangements to ensure that algorithmic trading systems cannot create or contribute to disorderly trading conditions on the market including systems to limit the ratio of unexecuted orders to transactions that may be entered into the system by a member or participant, to be able to slow down the flow of orders if there is a risk of its system capacity being reached and to limit the minimum tick size that may be executed on the market. Circuit breakers must therefore be in place to temporarily halt trading if there are sudden and unexpected price movements.

In another nod to the challenges posed by Algorithmic traders, MiFID 2 will also require Member States to ensure that regulated markets have rules on co-location of servers that are transparent, fair and non-discriminatory.

What happens next?

MiFID 2 will bring regulatory oversight to a sector that was previously unburdened with such requirements. Inevitably there will be some teething problems as operators face up to the challenges introduced by the new requirements. The firms that prosper will likely be the ones that take note of the coming changes, and rapidly adapt to be able to succeed in the new regulatory environment.


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