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Mifid II: A cheat sheet on HFT, market data and more

Tuesday, April 26, 2016

The army of regulatory, legal and government affairs specialists in Europe's financial industry is once again earning its keep – buried under a fresh mountain of text from Brussels.

The focus this time is on new technical standards for the EU's revised Markets in Financial Instruments Directive, or Mifid II, which is set to come into force in 2018.

The European Commission produced more Mifid II standards on April 25 relating to its attendant regulation, Mifir, which will have to be enforced verbatim by national regulators. The rules still have to be scrutinised by the EU's co-legislators – the Council and the Parliament – but the market does not expect major changes.

The rules this time relate primarily to key definitions underpinning the revised trading rulebook. Here's your cheat sheet.

Algorithmic trading
Despite so many market participants in Europe using computer algorithms to trade, there remains no definition of what one is.

Mifid II changes that, now defining a trading system as algorithmic if "for any order or quote generation process or any process to optimise order-execution, an automated system makes decisions at any of the stages of initiating, generating, routing or executing orders or quotes according to pre-determined parameters".

This definition, though verbose, is important because it sets the scope for Mifid II's systems and control framework, designed to improve the resiliency of markets in times of stress. This framework is largely based on guidelines for automated trading adopted by the European Securities and Markets Authority in 2012, something already adhered to by high-speed trading firms that are members of industry trade body the FIA European Principal Traders Association.

Piebe Teeboom, FIA EPTA's secretary general, said: "Under Mifid II, a much broader community of market participants that undertake algorithmic trading activities will now be brought into the fold of these systems and controls rules."

High-frequency trading
Mifid II also sets a definition for high-frequency algorithmic trading, which is a subset of algorithmic trading. Any firm, when dealing on their own account, sending at least two messages per second in any 'liquid' instrument on any European market will be classified as an HFT. The same will apply to any firm sending at least four messages per second in all instruments being traded on any given venue. A message could be an order for an execution, as well as a cancellation or amendment of that order. An important part of many HFT strategies is the ability to rapidly cancel and replace orders on trading venues in order to keep their strategies in line with market conditions.

Many firms are likely to meet this definition but the consequences are actually relatively minor, including some additional reporting requirements, such as tagging trades with up to 34 fields of information. A firm meeting this definition will also not be able to exempt itself from having to license and authorise itself with regulators, in the same way that brokers do.

Further controls could be placed on these firms in years to come. Conor Foley, a government and regulatory affairs adviser at law firm Norton Rose Fulbright, said: "The risk in getting a definition of high-frequency trading is there would be nothing to stop much more onerous requirements being placed on the firms engaging in that activity in future, were there the political will."

Direct electronic access
Some HFT and proprietary trading firms that are not members of an exchange can gain access via the membership and connectivity of other firms, such as their broker. This is known as sponsored access or, in EU-regulatory speak, direct electronic access.

Any firm that is a user or provider of DEA will need to have appropriate systems and controls in place. More importantly, any DEA user will need to be licensed and authorised with regulators. This brings with it additional costs and is significant because previously firms that traded with their own capital did not have to adhere to such rules.

Under the standards published on April 25, a firm will be deemed a DEA user unless it “cannot exercise discretion regarding the exact fraction of a second of order entry and the lifetime of the order within that timeframe".

Sam Tyfield, a partner at law firm Vedder Price, said: "There will be some people who think the natural jitter within IT infrastructure is such that nobody can exercise discretion over the ‘exact’ time of order entry, so that definition will be looked at closely."

Market data
The cost of market data on European securities has been a long-running debate, centred on the perceived high fees charged by domestic stock exchanges. As had been expected, the new rules state that market data should be provided on a "reasonable commercial basis", imposing cost-based controls on data providers.

The rules state that the price of market data should be based on "on the cost of producing and disseminating such data and may include a reasonable margin". Data should also be provided on a "non-discriminatory" basis, with the same price and conditions offered to all customers, the rules stipulate.

To help regulators assess whether data is being provided on a reasonable basis, Mifid II will also require that data providers disclose some information publicly, including price lists and the proportion of revenues accounted for by data sales.

This part of the rulebook could have big consequences for exchanges, for which market data has become a lucrative business.

Anish Puaar, a market structure analyst at Rosenblatt Securities, said: "The proposal on market data is quite vague and gives exchanges the leeway to decide what contributes to their cost and therefore what they should be charging for data. However, this is perhaps the best the industry could have hoped for, as financial regulators were probably reluctant to impose more direct price controls on EU firms."

Systematic internalisers
An esoteric but important part of Mifid II's efforts to bring transparency to over-the-counter markets. Already established in equities, SIs are designed to create a regulatory wrapper where banks systematically and regularly execute client orders using their own capital (rather than sending such orders to an exchange, or by matching two opposing client orders). A requirement of being an SI in a particular instrument is that banks must make quotes publicly available in that security for orders up to a certain size.

Under Mifid II, being an SI will no longer be at a bank's discretion, it will be compulsory if they pass certain trading thresholds. Furthermore, the SI concept is also being extended to other asset classes, such as bonds. The rules on April 25 confirmed that any firm dealing in an equity that amounts to more than 0.4% of that stock’s average daily volume over a six-month period will be required to register itself as an SI in that instrument. For bonds, that market share threshold will be higher, at 2.5%.

There were fears in earlier drafts of the rules that banks would be deemed SIs in a whole class of bonds if they were an SI in any single bond of that class. The rules had been written in this way to implement the SI regime for new issues, which have no trading history. But banks feared it could have left them on the hook for providing quotes in an instrument in which they might never have traded.

The rules on April 25 corrected this, by saying that if a firm is an SI in one bond it would be an SI for bonds "issued by the same entity or by any entity within the same group". Therefore, a dealer deemed an SI in a Vodafone bond would automatically be deemed an SI in all Vodafone issues, as opposed to all other corporate bonds.

Arjun Singh-Muchelle, a senior adviser for capital markets at the Investment Association, said this definition was still concerning "given the broad nature of instruments an issuer could issue". He added: "A broker-dealer should only be determined as an SI on an instrument-by-instrument approach. This will help avoid inappropriate limits on the provision of market-making services or expose our brokers-dealers to undue market risk."

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