Sam Tyfield, partner, Vedder Price
Germany's high frequency trading [HFT] Act impacted most German market participants, including firms not typically considered high frequency traders. However, a number of industry players are asking ESMA to stick with the German model in Europe's upcoming Markets in Financial Instruments Directive II [MiFID II]. Implementing any legislation on this front will require a lot more work, so many market participants want the new regulations to build on existing German compliance already in place.
"It's too early to say. I see demand to follow the German high frequency trading law as a blueprint for Europe because the effort to make it workable has been done to a large extent," said Sam Tyfield partner at law firm Vedder Price.
German HFT regulations took effect on 15 May 2013 with reporting required from 1 April 2014. The Europe-wide MiFID II regulations cover far more than the HFT act and are expected to come into force in January 2017.
The European Securities and Markets authority [ESMA] consultation ended on 1 August 2014 and while the authority wants to harmonise regulation, it will not exceed its mandate or change MiFID II level 1 detail to make it happen.
Although still early days, initial indications are that the German financial markets regulator (BaFin) is satisfied with how compliance has been taken up. Media reports quote Karl- Burhard Caspari, BaFin's chief executive director of Securities Supervision and Asset Management, as saying that the country's high frequency trade reporting was leading the world.
Torsten Schaper head of Political Analysis at Deutsche Boerse, a German exchange said: "From our talks with market participants and regulators on this: all are content with the solution that is implemented so far."
Torsten Schaper head of Political Analysis, Deutsche Boerse
But it does seem that there was a rush to put controls in place and issue reports. PJ Di Giammarino, chief executive of think tank JWG Group said that since the implementation date "there's not been a lot of communication out of Germany regarding whether what (regulators) got is what they expected and to what extent they are able to make sense of it".
EVERYONE IS A HIGH FREQUENCY TRADER
The HFT Act required firms with activity in the German market to become licensed and to identify all algorithms used in generating orders with a unique identifier, or 'algo flag'. However, these seemingly simple initial requirements became very complex when put in practice.
"The definition of an algorithm under the German HFT act is very wide," explained Christian Voigt, senior regulatory adviser at trading technology provider Fidessa. "We are not only talking the high-end low-latency high frequency trading firms. We are talking about a lot of banks. Basically the vast majority of [order] volume is affected."
Di Giammarino noted that there are a lot of tricky definitional issues in terms of what is classified as a trading system and what gets caught as an algo.
"One could make an argument that a trader's spread sheet is a database, or if it has two tabs it could be a system," he said. In other words, if a firm was a German exchange member with a computer, they were likely classified as an HFT for the purposes of the Act.
Another difficulty popped up around licensing. The German requirement to obtain a license preceded any other national regulators, leaving those financial firms with German trades but headquartered outside of the country struggling to find a regulator to license them. As MiFID II comes into force and the national regulators catch up however, this is likely to change.
Generation of unique algorithm flags may have been one of the biggest challenges to overcome, but did provide some insight into the work required for this level of transparency.
Christian Voigt, Senior Regulatory Adviser, Fidessa
"If the German HFT act did something good, it showed us the complexity of the task," said Voigt. "And if you now want to implement the same regime across Europe on a much bigger scale, we need to take those lessons learnt and apply them, otherwise we will face massive challenges when coming up with a proper solution."
Adding to this complexity, exchanges are required to have a volatility interrupter or circuit breaker, establish order-to-trade ratio limits, set fees to penalise excessive usage as well as fix minimum tick sizes.
"Deutsche Borse Group has safeguards like volatility interruption in place that ensure orderly trading. (Safeguards) are in place since the introduction of electronic trading system," said DB's Schaper, adding that the implementation of the other HFT Act controls are all in place.
TRADE SURVEILLANCE SUCCESS?
With the broad definition of algorithms, experts expect the vast majority of order flow to be in scope, yielding a mountain of complex data in HFT reporting.
At time of writing, regulators had stored about three months of data, which Voigt said is not 'terribly much'. "It is such a complex matter they obviously need some time and knowledge to analyse and really understand what the data is telling them".
Others question whether the data will ever provide useful information that improves surveillance and market stability.
"There's an inherent belief on the part of European regulator that by getting more information they will know more about the entirety of the financial system, the reality might be the opposite," JWG's Di Giammarino said. "We may well be creating an illusion of control by establishing a series of point-to- point observations without being able to put them in context."
On 22 May, ESMA issued a 311-page consultation paper with 245 questions to solicit input from industry. Buried on page 230, ESMA indicated it might follow the German lead by using the Act's HFT definition: 75,000 messages per day, detailed as 2 messages per second, over a 10GBit/second line, colocated with the exchange.
"What was implemented in the context of
the German HFT law was basically what was discussed at MiFID II level 1 at that time," said Vedder Price's Tyfield. "I can't say it's going
to be implemented in the same way as we are still in the consultation and discussion period, but the philosophy seems to be the same - they want to be able to identify at as granular a level as possible who's in charge of developing and putting the trades on, so they know whose door to kick in if something goes wrong."
Along with the similarities, MiFID II also adds algorithm testing to the requirements. "There are several ESMA algo testing requirements which are not in the BaFin act - such as initial testing, testing in a non-live environment, and how the implementation is done," said Daniel Simpson, JWG's regulatory analyst.
Although the objective is to harmonise policies across Europe, there is a risk that detailed implementation may vary between member states. Specifically for algo flags on exchanges, MiFID II wants harmonisation but does allow exchanges flexibility in defining their algo flags and does not grant ESMA a mandate to harmonise.
"Since EMSA doesn't have a mandate to make sure of that, we might end up in a really complicated situation where some exchanges diverge from others," warned Voigt.
With roughly 250 exchanges licensed in ESMA's current MiFID database, there is a theoretical risk that each could come up with a different flag process, adding complexity and making pan-European surveillance very difficult.
NEED TO KNOW
PJ Di Giammarino, CEO, JWG Group
ESMA invited market participants to Paris on 7 and 8 July to discuss the items raised in the 22 May consultation paper. Voigt took two key points away from the meeting: that ESMA was at the meeting to listen rather than make pronouncements, and that they will stick very closely to the level 1 text.
Other regulations, such as EMIR, will cause overlap in trading requirements. Di Giammarino estimated there will be 6.2 billion trade reports done this year in Europe to comply with EMIR (European Market Infrastructure Regulation), which involves regulations pushing derivatives to clearing.
Voigt noted that "ESMA will try to align those two trade reporting [EMIR and MiFID II] as much as possible, however they have already said due to differences in the level 1 text
there will not be 100 per cent overlap, so this complexity needs to be managed by the market participants."
While acknowledging he is a Cassandra, Tyfield said that "woolly thinking" can have "unintended consequences ... with a much wider impact than possibly drafters (of the regulations) anticipated."
As an example, he pointed to an old draft of the Market Abuse Regulation (MAR) that would have made a firm non-compliant for just having an electronic trading system capable of breaching the regulation.
"Now that is impossible - that's like saying if I own a telephone that can be used for making dirty phone calls, then I am already guilty of making dirty phone calls. It is an impossible ask," he added.
Still, regulators feel pressured and empowered amid widespread controversy on the role of HFT in the markets. Events such as the flash crash, Knight Capital's meltdown as well as books such as Flash Boys alleging that markets are rigged and HFT is akin to front-running loom large in the US.
"Most of the US discussion is also being discussed in Europe, but there is currently no need for this as we have a different market structure, and events like the US flash crash or the default of Knight Capital did not happen and will not happen in Europe," said Schaper of Deutsche Borse.
Daniel Simpson, Regulatory Analyst, JWG Group
"I think Europe and Germany should be quite proud about the stability of the established infrastructure and it needs to be ensured we don't get disproportionate regulation such as a ban of high frequency trading, order resting times or other concepts that would decrease liquidity of financial markets."
DEVIL AND DETAILS
The MiFID II implementation
is complex, especially as the
details are worked out.
There are timelines in place but delays could compress implementation time, leaving market participants scrambling to hit the January 2017 deadline.
"There are some things which affect everybody else but probably at the moment lie firmly within the bailiwick of those who deal with the electronic trading side - for example
clock syncronisation - which is a fundamental building block for certainty and market surveillance," said Tyfield.
He added that there is an enormous amount of work yet left to provide transparency along the various paths of MiFID II. "People might brush over it and think that's .... to do with the algo boys, but it will and should effect the entire industry."
Di Giammarino noted
that there is a lot of
regulation coming over the
next couple of
years and implementing it will be expensive, disruptive and create an awful lot of uncertainty over what is the right way to do things.
"From an investment firm's perspective, they have to be aware that at the end of the day, though detailed work in the basement is going on now, ultimately it is going to affect the kind of strategies they can direct from the top floor."