A game of cat and mouse. Technological development more often than not stays ahead of regulators. Each new technological advance or disruption carries risks for the stability of things and advantages for those who are at the forefront.
Regulators try to set rules and good practices that limit possible abuses and bring transparency to the participants.
In this post, we will review the European regulation applied in the 27 EU member countries, specifically for algorithmic trading.
Technology, Finance, and Regulations
The technology revolution has changed the way we relate to the world and the way we do business. But far from having reached maturity, the revolution continues on its course revealing even new technologies and disruptive methods that are capable of changing entire industries and generating completely new businesses.
The financial industry has undoubtedly been at the forefront of this revolution by investing huge amounts of money in the adoption and improvement of multiple technologies (hardware, databases, cybersecurity, blockchain, management, B2B, B2C, SOA, FIX, FinTech and many more).
Focusing on the investment industry, once upon a time prices were transmitted by telegraph and settlement was done by hand collating physical papers. Those days are long gone.
Why Regulations for Algorithmic Trading?
The book Reminiscences of a Stock Operator by Edwin Lefèvre tells the story of Jesse Livermore and masterfully describes how the industry operated in the late 19th and early 20th centuries. Today, millions of transactions take place around the globe in a matter of milliseconds with fast and reliable settlement processes.
Back then or now, technological disruptions create abnormalities and holes that cutting-edge companies and intelligent individuals often exploit for their benefit. I like to think of Jesse Livermore as one of the first hackers in history because he managed to exploit the weaknesses of the telegraph, among his many “tricks”. In our time there are many modern Jesse’s who exploit the technology capabilities for their own benefit.
In the past, as in the present, the exploitation of abnormalities can cause dysfunctions that can alter the correct and efficient functioning of the markets.
If someone has an advantage that brings her substantial profits, she will hardly stop exploiting it. Sometimes, the advantage is completely honest and it’s an obligation to exploit that edge, but at other times, the advantage is unethical and unfair to the rest of competitors. This can jeopardize the industry stability, and so regulators try to stop the abuse and establish a framework for industry participants. This article discusses benefits but fears of accidents of trading algorithms.
European Regulatory Agencies
Each country has one or more regulatory agencies, including the case of Europe where the regulatory agencies of each country adopt the European regulations. Here is a non-exhaustive list of some regulatory agencies around the world: (complete list)
- European Securities Markets Agency (ESMA)
- Financial Market Authority of Germany (FMA)
- National Securities Market Commission of Spain (CNMV)
- UK’s Financial Conduct Authority (FCA)
- USA Securities and Exchange Commission (SEC)
- USA Commodity Futures Trading Commission (CFTC)
- Securities and Exchange Board of India (SEBI)
- China Securities Regulatory Commission (CSRC)
Therefore, regulatory agencies try to set the rules of the game and act as a referee in case of conflict or non-compliance. In this section, we are going to look at the specific case of Europe.
European Securities Markets Agency (ESMA)
European Securities Markets Agency (ESMA) is an independent EU Authority that contributes to safeguarding the stability of the European Union’s financial system by enhancing the protection of investors and promoting stable and orderly financial markets.1
In order to achieve its objectives, the agency publishes mandatory standards and good practices and supervises their compliance. The regulatory agencies of each member country are responsible for implementing and supervising these regulations in their home country. Europe, therefore, sets the rules of the game for the 27 countries that make up the EU (after Brexit). Here is the list of countries that must be in compliance with European regulations:
- Austria,
- Italy,
- Belgium,
- Latvia,
- Bulgaria,
- Lithuania,
- Croatia,
- Luxembourg,
- Cyprus,
- Malta,
- Czechia,
- Netherlands,
- Denmark,
- Poland,
- Estonia,
- Portugal,
- Finland,
- Romania,
- France,
- Slovakia,
- Germany,
- Slovenia,
- Greece,
- Spain,
- Hungary,
- Sweden, and
- Ireland.
In this next section, we are going to put the focus on the new European legal framework MiFID2 (Markets in Financial Instruments Directive), MiFIR (Markets in Financial Instruments Regulation) and MAR (Market Abuse Regime). They are an attempt to update the regulation to new technological advances and although the scope is Europe it has common aspects to other countries or serves as a reference to others as well. Read a summary here.
In short, Europe, through ESMA publishes binding directives and regulations for EU member states, each country, through its regulatory agency (FDA of Germany, CNMV of Spain, etc.), implements, supervises and reports back to ESMA.
This means that all market participants (banks, investment firms, funds, agents, brokers, systems, etc.) operating in a given country must adapt to them, and the country’s regulatory agency is responsible for enforcing and supervising the participants’ compliance.
MiFID2 (Markets in Financial Instruments Directive)
MiFID2 is the Directive 2014/65/EU on Markets in Financial Instruments for better regulated and transparent financial markets. You can read the official summary here. In short:
- It aims at making financial markets in the European Union (EU) more robust and transparent.
- It creates a new legal framework that better regulates trading activities in financial markets and enhances investor protection. The new rules, called ‘MiFID 2’, revise the legislation currently in place and were applicable from January 2018.
How?
- Ensuring financial products are traded on regulated venues
- Increased transparency
- Limiting speculation on commodities
- Adapting rules to new technologies
- Reinforcing investor protection
These objectives are achieved through a set of specific guidelines:
- Guidelines - Systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities
- Guidelines on transaction reporting, order record keeping and clock synchronisation under MiFID II
- Guidelines on the calibration of circuit breakers and publication of trading halts under MiFID II
- Guidelines on cross-selling practices
- Guidelines on the management body of market operators and data reporting services providers
- Guidelines on MiFID II product governance requirements
- Guidelines on certain aspects of the MiFID II suitability requirements
- Guidelines on remuneration policies and practices (MiFID)
- Guidelines on cooperation arrangements and information exchange between competent authorities and between competent authorities and ESMA
- Guidelines on the application of C6 and C7 of Annex 1 of MiFID
Who should adopt these guidelines?
All market participants required by law (Article 1) and other participants who are service or system providers. Thus, each participant, depending on her involvement in the market, will have to adopt one or more of these guidelines.
MiFIR (Markets in Financial Instruments Regulation)
Regulation Nº 600/2014 establishes a common regulatory framework on financial instruments and market participants to provide transparency and security to investors. The key points are:
- Transparency for trading venues
- Transparency for equity instruments
- Transparency for non-equity instruments
- The obligation to offer trade data on a separate and reasonable commercial basis
- Transparency for systematic internalisers and investment firms trading o-t-c
- Transaction reporting
- Derivatives Regulation Nº 648/2012 on OTC derivatives, central counterparties and trade repositories
- Non-discriminatory clearing access for financial instruments
- Supervisory measures on product intervention and positions
- Product monitoring and intervention See the recent announcement on CFDs and Binary Options intervention measures
- Positions
- Provision of services and performance of activities by third-country firms following an equivalence decision with or without a branch
MAR (Market Abuse Regime)
Regulation Nº 596/2014 establishes a common regulatory framework on insider dealing, the unlawful disclosure of inside information and market manipulation (market abuse) as well as measures to prevent market abuse to ensure the integrity of financial markets in the Union and to enhance investor protection and confidence in those markets.
In short, this regulation tries to establish the rules of behaviour of insiders and the capacity of regulatory agencies to supervise and sanction bad practices.
EU Algorithmic Trading Regulation
We here at QuantInsti love algorithms, so let’s narrow the focus to look at this particular regulation aspect.
We are going to review the regulations from three different points of view:
- High-frequency trading
- Companies involved in algorithmic trading
- Individuals involved in algorithmic trading
High-Frequency Trading
What does ESMA mean by HFT?
‘High-frequency algorithmic trading technique’ means an algorithmic trading technique characterized by:
(a) 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;
(b) system-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders; and
(c) high message intraday rates which constitute orders, quotes or cancellations;
High-Frequency Trading for companies or individuals have special requirements in order to operate the markets, here you can read a summary of the Market Structure and Regulatory Changes in HFT.
Check the Directive 2014/65/EU paying special attention to:
- Article 17 on Algorithmic trading
- Article 48 on Systems resilience, circuit breakers and electronic trading
- Article 90 on Reports and review
Companies involved in algorithmic trading
What does ESMA mean by algorithmic trading?
‘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.
It 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;
Check the Directive 2014/65/EU paying special attention to:
- Article 17 on Algorithmic trading
- Article 48 on Systems resilience, circuit breakers and electronic trading
- Article 90 on Reports and review
Individuals involved in Algorithmic trading
All right! Unless you fall into the HFT category, trade for the benefit of others or the number of contracts in commodities exceeds a certain amount, you will be exempt from the regulations.
But what happens if you are an independent developer for a company involved in algorithmic trading or HFT? you must take into account the regulation again so that your client can comply with it.
In any case, knowing the regulations will help you develop more robust algorithms, controlling risks and easy to trace backwards. Check the Directive 2014/65/EU paying special attention to:
- Article 17 on Algorithmic trading
- Article 48 on Systems resilience, circuit breakers and electronic trading
- Article 90 on Reports and review
As an individual, there are some regulations about position limits.
Check the Directive 2014/65/EU paying special attention to:
- Article 57 on Position limits and position management controls in commodity derivatives
- Article 58 on Position reporting by categories of position holders
Conclusion
Europe, through the ESMA, establishes the framework which governs the actions and good practices of market participants, be they companies, institutions, individuals, systems, procedures or financial instruments. Each of the 27 countries of the union, through its home regulatory Agency, is responsible for promoting implementation and compliance monitoring. The main documents are:
- MiFID2 Markets in Financial Instruments Directive 2014/65/EU
- MiFIR Markets in Financial Instruments Regulation Nº 600/2014
- MAR Market Abuse Regime Regulation Nº 596/2014
Each player, large or small, must adapt their operations to the regulations that apply to them particularly on the basis of their business.
Companies and individuals involved in markets with systems and/or algorithms should pay special attention to the following working guidelines and to Directive 2014/65/EU:
- Guidelines - Systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities
- Guidelines on transaction reporting, order record keeping and clock synchronisation under MiFID II
- Guidelines on the calibration of circuit breakers and publication of trading halts under MiFID II
The regulation of financial markets are the rules and good practices that must be complied with by the participants, the regulatory agencies are in charge of control and supervision. You can also learn it in the Executive Programme in Algorithmic Trading (EPAT®).
Disclaimer: All data and information provided in this article are for informational purposes only. QuantInsti® makes no representations as to accuracy, completeness, currentness, suitability, or validity of any information in this article and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.
Suggested Reads:
- Market Structure and Regulatory Changes in HFT
- Algorithmic Trading In India: History, Regulations And Future
