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Europe's algorithmic trading rules come under the microscope

Principal trading firms discuss ESMA's latest algorithmic trading proposals

4 March 2021

FIA European Principal Traders Association (FIA EPTA) hosted a webinar on 24 February that reviewed European algorithmic trading rules under MiFID II and discussed suggestions put forward by the European Securities and Markets Authority (ESMA) for potential changes to the regime.

Rules around algorithmic and high-frequency trading, as well as various aspects of market microstructure, form an important cornerstone of the MiFID II rulebook. In December 2020, ESMA published a consultation paper, evaluating the algorithmic trading regime ahead of the upcoming MiFID II Review by the European Commission. ESMA also made suggestions for potential new additions to the regime.

In this webinar, experts from the principal trading community discussed ESMA’s proposals and provided a practitioner's perspective on what has worked well and what should be improved or changed.

The webinar consisted of three main discussions: the scope of the algorithmic trading regime; market resilience and practical measures to further improve European market structure; and the impact and regulatory status of "speedbumps" installed by exchanges to slow down trading. The discussion took place ahead of ESMA's consultation closing date of 12 March.

Success of RTS 6

Participants discussed how algorithmic trading has brought significant benefits to markets and investors by lowering transaction costs and narrowing bid-ask spreads. It has also become increasingly widespread over the past 10 years, accounting for more than 80% of all trading activity in certain asset classes.

The panelists noted that over the past decade, FIA associations and members have contributed to best practice guidance on the development and operation of automated trading systems. Many of these provisions can be found in the MiFID II algorithmic trading framework, which the panelists said has raised the bar globally on compliance.

The panel agreed that the rules within RTS 6 under MiFID II, which seek to balance the benefits for market efficiency of algorithmic trading with potential risks attached, are well designed and fit for purpose. They also agreed that the definition and basic concepts of high-frequency trading (HFT) and the requirements that are associated with HFT under MiFID II still apply, although metrics should be non-discriminatory and measurable so market participants can predict whether they fall into the definition.

In the area of direct electronic access, ESMA makes the case for not requiring DEA users to be authorized. Panelists agreed, although they said they support the strengthening of some aspects of DEA rules, including a clearer authorization requirement for DEA providers and regulatory transparency for underlying clients.

Market resilience

The second section of the webinar focused on trading venues, which facilitate algorithmic trading and are key for maintaining an orderly market in Europe.

Panelists noted MiFID II aims to ensure that trading venues do not contribute to any kind of systemic disruption, that their systems are resilient, and that they require similar standards for those using algorithms. Trading venues are expected to work with members to test their algorithmic trading systems, although the panel noted that currently there are no specific definitions and standards for what needs to be tested.

MiFID II also places obligations on regulated markets to use circuit breakers to temporarily halt or constrain trading if there is significant price movement in a financial instrument during a short period. These worked extremely well during periods of high volatility in March and April last year, the panelists noted.

"ESMA talks about circuit breakers [in the consultation paper] and asks if there is a need for a change. Our general view is no, they work well and are very much fit for purpose," one panelist said.

In terms of outages, the panel agreed that when these happen there should be a minimum standard of communication from trading venues, and that exchanges should have clear playbooks ahead of time so that participants know what to expect. This information should be the same for all participants, one panelist noted, and should ideally be readable by both humans and trading systems.

They should also provide information on what trades were done, when orders were cleared from the book and lessons learned from the incident, the panelist said.

Speedbumps

Several new requirements on market microstructure were introduced under MiFID II, including co-location rules and rules around market making and order-to-trade ratio among others.

In its consultation, ESMA is also considering whether additional aspects should be taken up in the rule book, including speedbumps, a mechanism implemented by some trading venues that consists of a delay applied to incoming orders before they enter the matching engine for execution. Currently there is no specific legal provision targeting the introduction and functioning of speedbumps.

"There are key questions that must be asked," one panelist said. "For example, who does the speedbump apply to? Does it apply to all participants on the venue equally? Is it symmetric in application or does it apply to certain participants or orders differently than others, meaning that it's asymmetric in application? What is the asset class in which it has proposed? What is the length of the speed bump?"

The panelists agreed transparency is key around these types of proposals and information about the rationale should be clearly articulated to members of the exchange. Details associated with the operation of the speedbumps and objective metrics to evaluate the success of their implementation should also be provided.

"In the EU, there isn't a consistent or harmonized procedure regarding how trading venue rule proposals are considered or evaluated, and this is an important area that ESMA and NCAs should look at closely," one panelist said. "We recommend that there be a more harmonized procedure adopted across the EU." The EU equities markets are not well-suited for speedbumps, particularly asymmetric speedbumps, the panelists said. Implementing a speed bump on one venue could negatively impact fair and orderly trading across the market and, due to the interconnected nature of the equities markets, impact related asset classes, such as ETFs, they said.

Look out for more insights on the topic in FIA EPTA's response to ESMA’s consultation paper later this month.

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