8. Algorithmic and High Frequency Trading (HFT) Requirements
Who should read this chapter?
This chapter is of interest to: algorithmic trading and HFT firms; proprietary traders who
engage in algorithmic trading techniques, including HFT and banks with a proprietary
algorithmic trading desk. It may also be useful for trade bodies that represent those
firms, and trading venues or others with an interest in this topic.
This chapter is applicable to operators of MTFs, prospective operators of OTFs and
authorised persons engaging in algorithmic trading.
Technological developments in trading, particularly algorithmic trading have driven the need for new legislation in MiFID II. This legislation will determine the capacity and arrangements needed to manage MTFs and OTFs that allow or enable algorithmic trading to take place. MiFID II also contains obligations, systems and controls for algorithmic investment firms to mitigate the risks arising from algorithmic trading, including HFT.
We are proposing changes to MAR 5 and provisions in the new MAR 5A to transpose the provisions in Title III of the recast MiFID that apply high-level systems and controls requirements for algorithmic trading to MTFs and OTFs. More detailed requirements are contained in the draft RTSs mentioned above to which we provide references in the Handbook.
We are also proposing to introduce a new MAR 7A to give effect to article 17 of MiFID II which contains systems and controls requirements for investment firms undertaking algorithmic trading. More detailed requirements are contained in, from the list above, draft RTSs 6 and 8 to which we provide references in the Handbook. Key parts of the new Handbook provisions include:
- high-level requirements for investment firms engaging in algorithmic trading
- requirements for high frequency traders
- requirements for those providing Direct Electronic Access (DEA)
- new rules for a person who acts as a general clearing member
Some of the proposed MAR 7A content is closely linked to the SYSC provision in the FCA Handbook, we propose to include flags in the relevant parts of SYSC to point the reader to MAR 7A. An alternative option would have been to add the requirements under article 17 MiFID II into SYSC. We prefer to create a new, dedicated section for algorithmic trading and other relevant firms since the inclusion of these provisions in SYSC would require an extension that would only apply to these specific firms.
Content of proposed MAR 5 & MAR 5A - Systems and Controls for Algorithmic Trading on MTFs and OTFs
In the current Handbook, there are references to the ESMA’s 2012 automated trading guidelines. These guidelines formed the basis of two RTSs. The references to the 2012 guidelines will be removed and replaced with transposition, or references to the relevant MIFID II text.
We propose to add sections in MAR 5.3A and in MAR 5A.5 for the systems and controls, to ensure that MTFs and OTFs have in place appropriate capacity and arrangements to manage the risks of algorithmic trading. The systems and controls utilised by an MTF or OTF must be appropriate to the nature, scale and complexity of their business.
One of the risks of trading algorithmically, particularly when using a HFT technique, is that the number of messages sent from the trader to the MTF or OTF tends to be higher than non-algorithmic strategies. The increased number of messages can lead to the trading system experiencing higher demands when allowing or enabling algorithmic trading. The new Handbook rules in MAR 5.3A.2(2) and MAR 5A.5.2(2) aim to mitigate this risk by making it a requirement that the trading systems must be resilient and have the capacity to deal with peak order and message volumes.
An MTF or OTF must have the ability to ensure orderly trading under severe market stress, and must have systems and controls in place that can cope in stressed market conditions.
The new rules in 5.3A.2(4) and MAR 5A.5.2(4) state that business continuity arrangements must be effective enough to ensure that the services the business provides can continue where there is a failure of its trading systems, and that the business should test its systems and controls.
In order to prevent market crashes due to ‘fat finger’ trade entry, or the submission of erroneous trades, MAR 5.3A.2(5) and MAR 5A.5.2(5) require MTFs and OTFs to have mechanisms to manage volatility. These mechanisms include the need to have in place systems and controls to reject orders that exceed predetermined volume and price thresholds, or those that are clearly erroneous.
The new rules in MAR 5.3A.2(7) and MAR 5A.5.2(7) aim to give the MTF or OTF the ability to ensure that algorithmic trading systems cannot create or contribute to disorderly trading conditions.
If the algorithmic trading systems create disorderly trading conditions, we expect the MTF or OTF will be able to manage those trading conditions. Measures to do this include limiting the ratio of unexecuted orders to transactions that may be entered into the trading system by a member or participant.
MAR 5.3A.2(8) and MAR 5A.5.2(8) Handbook rules also state that the MTF or OTF must have the ability to slow down the flow of orders if there is a risk of breaching the system capacity.
RTS 11 on tick sizes introduces a pan-European tick size regime for equities, equity-only ETFs and Depositary Receipts. MAR 5.3A.14 and MAR 5A.5.14 Handbook rules mandate the MTF or OTF to adopt and enforce the minimum tick-size in the RTS.
Members and participants are required under MAR 7A to carry out appropriate testing of algorithms. Under MAR 5.3A.2(10) and MAR 5A.5.2(10), an MTF or OTF is required to provide an environment for this testing. Testing of algorithms is a precautionary measure to prevent algorithms that contribute to, or cause, disorderly trading conditions from being used in the markets. Further details of the testing environments that MTFs and OTFs must provide are elaborated in RTS 7.
MiFID II introduces new requirements for all investment firms pursuing a market making strategy on an MTF or OTF. New rules in MAR 5.3A.3 and MAR 5A.5.3 state the obligations for the MTF and OTF providing the scheme, which needs to be appropriate to the nature and scale of the MTF or OTF. This point is explained further in RTS 8.
The MTF or OTF is required to halt or constrain trading if there is a significant price movement on their market. They will need to report the parameters for halting or constraining the trading to us. The obligation to make the report is set out in MAR 5.3A.7 and MAR 5A.5.7.
MiFID II introduces the concept of ‘material market in terms of liquidity’. ESMA will assign this title each year to the trading venue deemed to have the most liquid market for a particular financial instrument in the EU. Once that market has been named, it must (if UK based) notify us of any halts to trading that occur in the financial instrument that it is material for. This obligation is set out in MAR 5.3A.8 and MAR 5A.5.8.
Under MiFID II, the principles of fairness, transparency and non-discrimination must be applied
to co-location services and also to the fees charged and rebates given by MTFs and OTFs. These
obligations can be found in MAR 5.3A.10 and 5.3A.11 and MAR 5A.5.10 and 5A5.11. RTS 10
provides more clarity and includes information on banned fee structures.
To be able to distinguish between the algorithms of different firms, under MAR 5.3A.13 and MAR 5A.5.13, MTFs and OTFs will require members or participants to flag the orders generated by algorithmic trading. The features that will need to be flagged are the different algorithms used for the creation of orders and the people responsible for the orders initiated by the algorithm.
The new rules in MAR 5.3A.17 and MAR 5A.5.17 provide for the MTF and OTFs to synchronise the business clocks they use to record the date and time of any reportable event.
MAR 5.3A.2(7) and MAR 5A.5.2(7) requires an MTF or OTF to have the ability to set out the maximum order to trade ratio (OTR) allowed on their venue. To aid the setting of the OTR, RTS 9 prescribes the methodology to calculate the OTR. It is part of the requirement that the venue has to ensure the potential risks of the use of algorithmic trading systems are capable of being managed.
New rules in MAR 5.3A.9 and MAR 5A.5.9 mandate that where a firm allows DEA to an MTF or OTF it operates, it must follow certain requirements.
Q17: Do you agree with our proposal to add in the rules outlined above to our Handbook? If not, please give reasons why
Overview of MAR 7A requirements – Systems and controls for algorithmic trading for investment firms and for general clearing members
Content of proposed MAR 7A
In the current Handbook, there are references to ESMA’s 2012 automated trading guidelines. These guidelines formed the basis of two RTSs. The references to the 2012 guidelines will be removed and replaced with transposition, or references to the relevant MIFID II text.
MAR 7A sets out the additional MiFID II requirements which an algorithmic trading firm must comply with, in addition to the SYSC requirements. As such, the content of the new chapter should be read in conjunction with the SYSC part of the Handbook.
As HFT is a subset of algorithmic trading, persons engaging in HFT techniques must abide by the general rules which apply to algorithmic traders, as well as specific rules for HFT.
MiFID II mandates that a person notifies us if they engage in algorithmic trading. Where a person uses a HFT technique, they will generally also be subject to our authorisation. So if a person uses a HFT technique, they should consider the need to be authorised by us and notify us that they are engaged in algorithmic trading.
In addition to notifying us, the firm must also notify the competent authorities of the trading venues at which it engages in algorithmic trading as a member or participant of the trading venue.
The purpose of the organisational requirements is to ensure that the firm undertaking the algorithmic trading has effective systems and controls which are suitable to the business it operates.
Where an algorithmic market making strategy is used, the firm must enter into a binding written agreement with the trading venue to make markets for a specified period of time. This is in order to improve the availability of liquidity in the markets, particularly in times of high volatility. The terms of the market making agreements are left up to the trading venue and market maker to determine, but should include the minimum requirements as set out under MiFID II. RTS 8 provides more details on when an investment firm is obliged to enter into a market making agreement, and when it is appropriate for a trading venue to have a market making scheme in place.
MAR 7A includes the rules for firms that provide DEA to a trading venue. If DEA is provided to a UK trading venue, the DEA provider must notify us that they undertake this activity. The DEA provisions set out the systems and controls that the DEA provider must have in place to prevent trading by clients that may create risks to the clients themselves, or create or contribute to a disorderly market. The controls include real-time monitoring of the transactions made by the clients using the service to ensure that the rules of the trading venue are being adhered to, and that they are not creating or contributing to disorderly markets. Should the DEA provider discover conduct that may involve market abuse, they are obliged to notify us.
Before provision of DEA, a due diligence of the prospective client must be undertaken to assess their suitability for using the service. RTS 6 remains applicable.
MiFID II article 17 gives CAs a choice regarding the frequency of the reporting requirements imposed on a firm regarding engagement in algorithmic strategies and systems and provision of DEA. The choice is to have either regular or ad-hoc reports. We have considered the other reports that we will receive under the forthcoming legislation and decided to request ad-hoc reports.
A firm which provides the service of acting as a general clearing member of another person must have a binding agreement with the person receiving the service. Before the agreement, the service provider must carry out appropriate due diligence to assess the suitability of the client for the service provided. These requirements are intended to reduce the risks to both the service provider and the market.
Q18: Do you agree with our proposal to add a new section to MAR for Algorithmic and HFT firms, DEA providers and general clearing members? If not, please give reasons why
Q19: Do you foresee any implementation issues with the content of MAR 7A? If so, please provide examples
Q20: Are you in favour of the reports under MAR 7A.3.7 and MAR 7A.4.5 being submitted to us regularly, as opposed to an ad hoc basis?
Q21: If you are in favour, what will be the advantages of regular reporting as opposed to ad hoc reporting?
Q22: If we were to require regular reporting, what would be the cost to your firm?
- ^ RTS 6 – Regulation on the regulatory technical standards specifying the organisational requirements of investment firms engaged in algorithmic trading
- ^ RTS 7 - Draft regulatory technical standards on organisational requirements of RMs, MTFs and OTFs enabling or allowing algorithmic trading through their systems
- ^ RTS 8 - Draft regulatory technical standards on market making agreements and market making schemes
- ^ RTS 9 – Draft regulatory technical standards on the ratio of unexecuted orders to transactions
- ^ RTS 10 - Draft regulatory technical standards on requirements to ensure co-location and fee structures are fair and non-discriminatory
- ^ RTS11 – Draft regulatory technical standards on the tick size regime for shares, depositary receipts and exchange traded funds
- ^ RTS12 – Draft regulatory technical standards on the determination of a material market in terms of liquidity relating to trading halt notifications