Coffee, you and MiFID 2 Algorithmic and High-Frequency Trading under MiFID 2

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1 Coffee, you and MiFID 2 Algorithmic and High-Frequency Trading under MiFID 2 Jochen Kindermann Partner Marc Burgheim Head of Trading - Foreign Exchange (BayernLB) 23 July 2015

2 The promises and pitfalls of algorithmic trading & HFT For regulators, the interest in HFT is not simply around the novelty of 21st century technology, it s also the link between speed, market fairness, efficiency and safety which is clearly a much longer-running saga in financial services. A priority challenge for HFT specifically, which I m not sure has yet been honestly assessed by all players, is where the balance lies between the potential benefits against the potential costs. - Martin Wheatley, CEO, the FCA, at the Global Exchange and Brokerage Conference, New York Economic/ Scientific approach Emotional approach 1 / L_LIVE_EMEA2: v1

3 #Twitterflashcrash 2 / L_LIVE_EMEA2: v1

4 HFT-Activity by trader type 70% 60% 50% 40% 30% 20% HFT Traders Investment banks Other 10% 0% Value Traded Number of Trades Number of Orders Source: ESMA, BI analysis 3 / L_LIVE_EMEA2: v1

5 Challenges and goals Challenges & risks of HFT Market manipulation Cascading effects Overloading of the trade systems MiFID 2 will introduce a new regulatory regime to meet these challenges Strict regulation of HFT Goals of the HFT-regulation Increasing the stability and integrity Minimizing market risks Preventing market manipulation Closing regulatory gap Protection of long-term investors 4 / L_LIVE_EMEA2: v1

6 German front-running on HFT and Algo? German Hochfrequenzhandelsgesetz 1 (1a) S.2 Nr. 4 KWG (HFT) 2 (3) S.1 Nr. 2 WpHG ( Eigenhandel ) 33 (1a) WpHG (Organisational rules) 31f (1) Nr WpHG (MTF rules) 32c (5) WpHG (SI s) 26a BörsG (OTR-rules) 26b BörsG (Tick-size rules) 3 MaKonV RS 6/ BaFin FAQ s MiFID 2 Art. 4 (1)(39) and (40) (Definitions) Art. 17 (1) (Organisational rules) Art. 48 (6) (Organisational and Tick-size rules) ESMA Final Report 2014/1569 (Definition of algorithmic trading) Consultation Paper 2014/1570 (Draft RTS 13, 14 and 15) Level 2 (expected Q3 of 2015) ESMA Guidelines 2012/122 (organisational rules) 5 / L_LIVE_EMEA2: v1

7 MiFID 2 schedule of requirements Notification requirements Organisational requirements Disclosure requirements Recording & documentation Notification to home state regulator of HFT activity Notification to trading venue of HFT activity Effective systems & controls to ensure systems: Are resilient Have sufficient capacity Have appropriate trading thresholds/limits Prevent sending erroneous orders Firms providing DEA to clients engaging in HFT will be responsible to ensure that these clients comply with all requirements and monitor transactions (KYC) Algorithmic trading strategy Trading parameters & limits Key compliance & risk controls Details of testing arrangements Must keep accurate & time sequenced records of: All orders Cancellations Executed orders Quotations Effective business continuity arrangements to deal with any failure of trading systems Effective testing and monitoring systems 6 / L_LIVE_EMEA2: v1

8 Definitions under MiFID 2 (Level 1) Algorithmic trading, Art. 4 (1)(39) High-frequency trading, Art. 4 (1)(40) 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, and does not include any system that is only used 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 or for the confirmation of orders or the post-trade processing of executed transactions; high-frequency algorithmic trading technique means an algorithmic trading technique characterized by: infrastructure intended to minimize 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; system-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders; and high message intraday rates which constitute orders, quotes or cancellations; 7 / L_LIVE_EMEA2: v1

9 ESMA - Technical Advice ESMA carifies definition of HFT Firm-wide classification - once HFT, always HFT Three options as proxies for the identification of high message intraday rates Absolute threshold per instrument Absolute threshold per trading venue and instrument Relative threshold Liquid vs. Illiquid instruments within calculation Exclusion of client business from calculation Timing of calculation 8 / L_LIVE_EMEA2: v1

10 Differentiation - algorithmic & high-frequency trading Algorithmischer Handel Organisation, Reporting, Compliance HFT You could run the system and go to the beach Authorisation 9 / L_LIVE_EMEA2: v1

11 License requirement for HFT Persons dealing on own account in financial instruments [ ] unless they are market makers members of or participants in a regulated market or an MTF have direct electronic access to a trading venue apply a high frequency algorithmic trading technique Expanded scope of authorised services 10 / L_LIVE_EMEA2: v1

12 Entities within scope of HFT Model A Prop. Trader Ltd. high-frequency algorithmic trading Exchange Model B Investment Manager provides DEA Bank Exchange Model C Trading Ltd. Bank Exchange Contract: provides algorithm HFT 11 / L_LIVE_EMEA2: v1

13 Overview of MiFID II Market Structures KEY ISSUES [1] MARKETS Regulated Markets (RMs) Multilateral Trading Facilities (MTFs) Systematic Internalisers (SIs) OTC Organised Trading Facilities (OTFs) Who is the operator? The Exchange The Exchange or the Firm Firm Firm The Exchange or the Firm A multilateral system operated by and /or managed by a market operator, which brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments A multilateral system operated by and /or managed by a market operator, which brings together multiple third-party buying and selling interests in financial instruments An investment firm that deals on its own account by executing client orders outside a trading venue. A multilateral system which is not an RM or MTF and in which multiple third-party buy and sell interests in bonds, structured finance products and derivatives. OTF operators have discretion as to how to execute orders, subject to pre-trade transparency and best execution obligation [1 12 / L_LIVE_EMEA2: v1

14 Organisational requirements Runs algos for bank Service Provider Bank Carries out algo trading Exchange Prop. Trader Ltd. Offers algos Service Provider 13 / L_LIVE_EMEA2: v1

15 Organisation, Art 17 (7) MiFID 2 ESMA only defines minimum parameters for internal organisation of algorithmic trading but investment firms are required to carry out a detailed and robust self-assessment ( SA ) of their activities on a regular basis SA has to be signed off by management Adequacy of SA and operational consequences should be subject to internal/external audit Minimum requirements for Algotraders 14 / L_LIVE_EMEA2: v1

16 Scoring list for SA Nature, in terms of regulatory status of the firm (and where applicable its DEA users), firm s role in the market level of automation of trading types and regulatory status of the instruments strategies the firm employs and risks latency sensitivity of the firm s strategies / trading type and regulatory status of trading venues and other liquidity pools accessed connectivity solutions extent of reliance on third parties for the development and maintenance of its algorithms or trading systems firm s ownership and governance structure firm s risk management, compliance, and audit structure and organization maturity of the firm and level of experience and competency of its personnel Scale, in terms of number of algorithms/strategies running in parallel number of individual instruments, products and asset classes traded number of trading desks and individual trading ID s messaging volumes monetary value of gross and net positions intraday and overnight; number of markets accessed either as a member/participant or via DEA number and size of the firm s (DEA) clients number of co-location or proximity hosting sites throughput size of connectivity infrastructure (gbit/sec) number of clearing members or CCP memberships the firm s size (no. of traders) / number of firm s physical locations, countries firm s annual earnings and profits 15 / L_LIVE_EMEA2: v1

17 Scoring list for SA Complexity, in terms of the firm s algorithms, coding, the inputs upon which the algorithms are reliant, the algorithms interdependencies, and/or the rule exceptions contained in the algorithms, or otherwise; the firm s trading strategies (e.g. whether these strategies relate to correlated instruments/products in multiple trading venues or other liquidity pools); the firm s trading systems (in terms of diversity of trading systems employed, extent of the firm s control over setting, adjusting, testing, and reviewing of its trading systems); the structure of the firm (in terms of ownership and governance and its organizational, operational, technical, physical, or geographical set up); diversity of the firm s connectivity, technology or clearing solutions; diversity of the firm s physical trading infrastructure; speed of changes (IT system, strategy, client etc.) level of outsourcing of key functions 16 / L_LIVE_EMEA2: v1

18 Draft RTS organisational requirements Business continuity arrangements Minimum list of plans for worst-case scenarios Duplicate (parallel!!) hardware Bespoke arrangements for all venues Initial reception by market participants: Focus on means, rather than outcome of compliance Effectiveness? Proportionality? 17 / L_LIVE_EMEA2: v1

19 Draft RTS organisational requirements Initial testing Physically segregated testing environment Performance simulations/back testing on every trading venue accessed For members and participants of a market: non-live testing on a trading venue testing environment Controlled (restricted) deployment Ongoing testing Change Management Review and sign-off procedures Compulsory annual stress testing Documentation of when a change was made who made the changes who approved the change the nature of the change 18 / L_LIVE_EMEA2: v1

20 Draft RTS monitoring Requirement for a kill-switch as a last resort in case of exceptional circumstances embedded in both the firms and the trading venues systems? Internal flagging of algos as a means of internal risk management Monitoring in real-time 19 / L_LIVE_EMEA2: v1

21 Draft RTS monitoring Ongoing monitoring requirement what does it mean for ESMA? Real-time: real-time monitoring is required for all algorithmic trading activity causing a threat to the firm s own risk management or the functioning of the market and should be able to correct such trading behaviour while it is still occurring T+1: other relevant events (market manipulation, specific order events) Strict regulation of HFT 20 / L_LIVE_EMEA2: v1

22 Draft RTS record keeping A description of the nature of each decision or execution algorithm; the trading strategies that each algorithm is deployed to execute (as well as changes to those strategies) Allocation of responsibilities regarding development of algos and algorithmic trading (compliance, IT, risk control) Contact details of the person in charge of each algorithm Each parameter set up to calibrate the trading algorithm of the investment firm at any given time Market data messages that the investment firm receives e.g. from trading venues Production date and modification date of each algorithm A designation to identify the algorithm within the investment firm responsible for each investment decision and execution System properties including the trading parameters and limits to which the system is subject and changes to those parameters and limits A description of the key compliance and risk controls Testing methodologies, test results and periodic reviews 21 / L_LIVE_EMEA2: v1

23 DEA Users due diligence requirements All the regular due diligence following from know-your-client (KYC) and antimoney laundering requirements The governance structure (including in particular risk management and compliance) and ownership structure An analysis of all algorithms the investment firm has received from the DEA user in order to deploy them for the execution of orders The training and competency of individuals entering orders Access controls over order entry The operational set-up of the DEA user Allocation of responsibility for dealing with actions and errors The financial standing of the DEA user The historical trading pattern/behavior of the DEA user (when available) 22 / L_LIVE_EMEA2: v1

24 DEA - Direct Market Access (DMA) All orders go through Broker s infrastructure Broker IM / Client Participant Pre-trade risk controls Exchange Order forwarded under Broker s MPID 23 / L_LIVE_EMEA2: v1

25 DEA - Sponsored Market Access (SMA) Broker Pre-trade risk controls Broker provides connectivity to exchange only IM / Client Participant Pre-trade risk controls? Exchange Order forwarded under Broker s MPID 24 / L_LIVE_EMEA2: v1

26 Order to transaction ratio (OTR) Order: submission, price and volume modifications, deletions OTR elements: total number of orders divided by the total number of transactions executed relative weight of orders and transactions in terms of value (turnover) relative weight of orders and transactions in terms of volume (number of shares or contracts). ESMA: OTR only to be determined for cash instruments that are traded on electronic trading venues Formula for calculation of OTR: average OTR on a given electronic OTR threshold = trading venue per group of instruments x Order of a market member 25 / L_LIVE_EMEA2: v1

27 Tick sizes Recap from ESMA Discussion Paper Option 1: Granular, two-dimensional (double entry) tick size table Each share, depending on its liquidity profile and its price, will be assigned a tick size Option 2: Binary tick size table (liquid/non-liquid) Single common tick size table, modeled on the existing FESE Table 2 ESMA Draft RTS Options 1 and 2 merged! Tick size depends on average number of trades per day on most relevant market in terms of liquidity. 26 / L_LIVE_EMEA2: v1

28 Draft tick size tables Draft final tick size table based on impact assessment and scenario analysis 27 / L_LIVE_EMEA2: v1

29 Flagging algorithms Art. 48 (10) MiFID 2 - Regulated markets required to identify orders generated by algorithmic trading, the different algorithms used for the creation of orders and the relevant persons initiating those orders Entire sequence of instructions (decision path) which effects that an order entry or its change or deletion is entered into the trading system of the exchange to be identified as an algorithm Identification obligation refers to the whole sequence of instructions (decision path) and not just individual elements A trading algorithm is deemed to be different and needs to be flagged differently if one or more of its constituent instructions were changed and therefore result in a different behaviour compared to the previous version 28 / L_LIVE_EMEA2: v1

30 Jochen Kindermann T: E: simmons-simmons.com elexica.com This document is for general guidance only. It does not contain definitive advice. SIMMONS & SIMMONS and S&S are registered trade marks of Simmons & Simmons LLP. Simmons & Simmons is an international legal practice carried on by Simmons & Simmons LLP and its affiliated practices. Accordingly, references to Simmons & Simmons mean Simmons & Simmons LLP and the other partnerships and other entities or practices authorised to use the name Simmons & Simmons or one or more of those practices as the context requires. The word partner refers to a member of Simmons & Simmons LLP or an employee or consultant with equivalent standing and qualifications or to an individual with equivalent status in one of Simmons & Simmons LLP s affiliated practices. For further information on the international entities and practices, refer to simmonssimmons.com/legalresp. Simmons & Simmons LLP is a limited liability partnership registered in England & Wales with number OC and with its registered office at CityPoint, One Ropemaker Street, London EC2Y 9SS. It is authorised and regulated by the Solicitors Regulation Authority. A list of members and other partners together with their professional qualifications is available for inspection at the above address. 29 / L_LIVE_EMEA2: v1