EC misses a trick in not defining HFT, argues K&L Gates
The failure by the European Commission to provide a proper definition of high frequency trading (HFT), despite placing great emphasis on its future regulation under MiFID II, could lead to furious lobbying by parts of the asset management industry, according to views put forward at a legal briefing hosted by K&L Gates in London.
HFT, along with algorythmic trading, has been picked out by the EC for specific regulatory action in the wake of the so-called “flash crash” seen in the US in 2010.
That event caused a massive systemic disuption over a brief period of time, but it took authorities such as the Securities and Exchange Commission considerable time to find out exactly how it happened.
That fear of systemic risk underlines the decision to put forward proposals for HFT and algorythmic traders, that would require investment firms to have specific systems and controls in place, as well as requiring detailed annual reporting on trading strategies, trading parameters/limits, key compliance and risk controls, and system testing.
“There is quite a lot in the draft directive that seeks to address this area,” said Philip Morgan, partner in K&L Gates’ investment management practice.
There is a definition in the draft for algorythmic trading, which is seen as “trading in financial instruments where a computer algorythm 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.”
However, Morgan said he believed that this definition will be hard fought over, along with HFT – for which there is no proposed definition – because as currently proposed it puts such traders in a “quasi-market maker” role.
Martin Cornish, K&L Gates partner, said that it is likely the decision to push through the draft in its current guise may also be the result of fears that national regulators do not equally and fully understand this part of the market, for example, so-called test bid activity, in which HFT investors have no intention of actually trading, but are merely looking for pricing trends.
As proposed, what the draft rules would do is create an audit trail, which is one of the issues the flash crash highlighted as lacking in existing regulations, Cornish said.
But, for the industry there is still a split between those such as long only mutual fund managers in Sweden – who have already complained to the local regulator about the effects of HFT on share prices in their own funds – and on the other hand those involved in HFT or algorythmic trading who argue that their activities may actually provide a liquidity benefit.
What is unknown at this point is to what extent either view will be represented in the feedback to the Commission on the draft as it stands.
Another key point for the financial services industry to appreciate is the way MiFID II will be implimented partly through a regulation (MiFIR) and partly through a diective.
The regulation element hits hardest against derivatives, where trading must move to a so-called “organised venue”, while there are also provisions in MiFIR that suggest the EC wants to project its effects outside the EU through “third country provisions” impacting firms without a branch in the EU.
Organised venues can be regulated markets, multilateral trading facilities, organised trading facilities or third country trading venues determined by the EC to be subject to equivalent requirements. The move to force derivatives to be traded via one of these comes about because of G20 pressure for transparency from this part of the industry.
The third country provisions of MiFIR raises the threat that third country actors simply bypass the EU. Morgan and Cornish suggested that the key question here is whether the US will follow or allow such a projection outside the EU of rules on investments. If it rejects the path the EC seems to be suggesting, then it could result in more assets being managed outside the EU’s reach.
Morgan and Cornish also discussed elements of the second Market Abuse Directive (MAD II), including the area of criminal sanctions.
They noted that one objective of MAD II would be to harmonise penalties across the EU, thereby defining insider dealing and market abuse both as criminal activities. Again, however, the proposals as they stand do not define minimum standards for sanctions, although the would have as an effect to make all related behaviour criminal. Currently, through the different national approaches it may be the case that, say, insider dealing is criminalised but not market abuse.