Executive summary

Welcome to this edition of "Being better informed", our monthly FS regulatory, accounting and audit bulletin, which aims to keep you up to speed with significant developments and their implications across all the financial services sectors.

In May the pace of regulatory developments remained unabated. The EBA launched a slew of draft RTS and ITS on various aspects of CRD IV. In particular, the consultation on own funds will draw much interest as the EBA seeks to harmonise the calculation of capital deductions across the EU. In addition, the EBA's consultation on defining material risk takers greatly expands the definition of banks' material risk takers subject to the cap to include all employees whose total remuneration is greater than €500,000. Asset managers should pay attention to this - similar requirements may be on the cards under UCITS V as politicians look to clamp-down on what they constitute as excessive pay across the wider financial system.

On AIFMD we saw a number of EU and UK developments which push forward on implementation. ESMA published a consultation to flesh out AIFMD's reporting obligations which will apply to AIFMs from January 2014. ESMA also approved cooperation agreements with over 30 non-EU countries, including regulators in the US, Cayman Islands, Bermuda and Jersey. These agreements are critical to the success of AIFMD because they enable non-EU AIFMs to continue to access the EU market after July 2013. Although negotiated by ESMA on behalf of EU Member States (as well as Croatia, Iceland, Liechtenstein, and Norway), these are bilateral agreements with require signatures of European supervisors with their non-European counterparts to come into effect.

In the UK, HMT published a Q&A looking at how AIFMD's transitional period will apply in the UK. Depositaries and non-EU managers received good news, with HMT choosing to apply a year transitional period for these firms. For full details on all the AIFMD developments please see the Asset Management section.

The Liikanen report, published in October 2012, looked at options for structural reform in the EU's banking sector. In May the EC published its second consultation on the available options. The EC raises some fundamental questions and any actual legislative proposal from the EC looks to be some way off. Several countries are moving ahead with their own proposals, including the UK and France. Therefore we welcome the EC's decision to take a measured approach.

The EC also published a legislative proposal in May for a single market in retail bank accounts across the EU. The proposed Directive would ensure that all EU citizens have access to basic banking services, increase transparency in banking fees and facilitate switching bank accounts, even cross-border. This Directive is a key element of the EC's work plan for retail financial services.

Lastly, the Council continues to publish progress notes on MiFID II. Only a few sticking points remain, but resolving these sticking points may still prove challenging. MiFID II has been debated for over 18 months now, and the task of taking negotiations forward will surely now carry forward to the Lithuanian Presidency from 1 July. This month's feature article looks at one of the key features of the MiFID II debate, regulating high frequency trading.

Laura Cox
FS Regulatory Centre of Excellence

HFT and the question of regulation

By Luke Nelson

As we look ahead to MiFID II, regulators in Europe and across the globe are already taking action in one of the key areas that MiFID II will address. Fuelled in part by controversy surrounding so-called 'flash crashes', regulators have been spurred to investigate market abuse related to high-frequency trading (HFT). The regulatory response has been mixed. In some cases, regulators have found only isolated cases of market abuse, and no evidence that normal HFT distorts markets, and have acted accordingly. In other countries, regulators have introduced onerous legislation to strengthen regulation and oversight of HFT, and have stepped up efforts to identify market manipulation. Regulators have also expressed concerns that HFT threatens market integrity through exacerbating information asymmetries and disadvantage buy-side and small market players.

What is HFT?

HFT covers a range of activities that share these common characteristics. HFT uses extraordinarily high-speed order systems, with speeds of less than five milliseconds. HFT often involves the use of algorithms for automated decision-making. HFT strategies usually feature very short time-frames for establishing and liquidating positions, and result in a high daily portfolio turnover. HFT often involves the submission of multiple orders which are cancelled in milliseconds if not immediately fulfilled. These strategies seek to end the trading day as flat as possible, with the aim of making profit intra-day, rather than inter-day.

Supporters of HFT believe it provides liquidity to markets, reduces volatility in most circumstances and enhances price discovery. Critics argue that the liquidity provided by HFT is false and can vanish during periods of market stress. While HFT may reduce volatility most of the time, it is also responsible for periodic "flash crashes", brief periods of extremely high volatility.

May 2010 flash crash

The 2010 flash crash saw the Dow Jones Index plummet over 700 points in a matter of minutes, dropping nearly 1000 points at its lowest point that day, before recovering to normal levels.

HFT was believed to have played a role in the crash but the cause was not immediately obvious. Some thought it was a result of a 'fat finger' error, others pointed to more malicious explanations. A joint SEC-CFTC investigation ran for six months and produced a report which identified the sale of 76,000 E-mini S&P 500 futures contracts by a large institutional investor as the initial motivator which, in turn, triggered further rapid sales by algorithms.

The SEC-CFTC report sets out one key lesson - under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements. This is particularly true when an automated execution algorithm does not take prices into account. The interaction between automated execution programmes, such as the one used by the institutional investor on 6 May 2010, and algorithmic trading strategies, can quickly erode liquidity and result in disorderly markets.

#Twitterflashcrash

The most recent flash crash occurred on 23 April 2013. A tweet sent from a hacked Associated Press Twitter account reported explosions in the White House, injuring the President. The Dow Jones immediately plunged 140 points, approximately 1%, but recovered just three minutes later.

Market infrastructure experts pointed to the incident as evidence of the way trading algorithms monitor and react to electronic news feeds. Although regulators have not identified all of the sellers, it is obvious that the decline in markets was triggered by algorithms responding to the combination of keywords such as 'White House' and 'explosion'. The presence of HFT in markets means that when such sell-offs are initiated, high-speed firms are driven into action, exacerbating and accelerating declines.

Different causes, similar effects, common conclusions

Although the 2010 and 2013 flash crashes had different causes, the effects were similar and some common conclusions can be drawn. The presence of HFT in markets means the effects of events in markets can become exacerbated and in some cases lead to extreme price volatility and a rapid erosion of liquidity. In both cases, it was the interaction of an automated process (the sale in 2010 and the social media reaction in 2013) and the HFT strategies that led to temporary volatility and disappearance of liquidity.

At the same time, both events were limited and markets were restored to normality within minutes (15 minutes in 2010 and 3 minutes in 2013). But HFT is not a victimless crime. Many investors, particularly those not employing HFT, are unable to respond with sufficient speed when market prices accelerate in these situations, which creates an unlevel playing field. Investors experience financial losses in these circumstances that they could not reasonably be expected to anticipate or protect themselves against. That in turn raises questions about market integrity and reputation of the financial markets.

Flash crashes have brought HFT to the attention of regulators across the globe. Keen to explore the impact of HFT on financial markets, regulators and governments have conducted studies and in some cases have taken steps to increase regulatory oversight. Without the flash crashes happening, and the volatility that HFT can cause being thrown into stark relief, it is unlikely that regulators and legislators would now be giving the practice so much attention.

Market abuse?

In addition to the impact of flash crash events, some regulators have expressed concern over the ability of HFT to facilitate market abuse. ESMA has identified a number of ways that automated trading can be used to manipulate markets. It is concerned that market participants may use 'ping orders', the practice of entering small orders to ascertain the level of hidden orders. Other abuses include quote stuffing, the practice of entering large numbers of orders to create uncertainty for other participants; layering and spoofing, the practice of entering manipulative orders that are not executed; and momentum ignition, the practice of entering orders intended to start or exacerbate a trend.

While HFT does not necessary enable these types of market abuse, it offers different and more effective means of engaging in abuses and the speed and volume of trades involved can make it harder for regulators to detect when they are happening.

Regulatory responses

Globally, regulators don't seem to be working on achieving global convergence on the regulatory oversight of HFT. This lack of coordinated effort may be in part because regulators have differing opinions about the dangers – or lack thereof – that HFT poses to financial markets and the wider economy.

In Germany, the High Frequency Trading Act became effective on 15 May 2013. The Act makes HFT a licensed activity, even if it is not a service offered to others. Any high-frequency trader who trades in German securities needs to apply for a BaFin licence or passport an existing licence from another EEA Member State. The Act requires market participants to ensure that they have properly configured trading systems and maintain an adequate ratio of orders to executed trades. Fees will be imposed on those who make "excessive use" of HFT. Market operators have the right to review algorithms and must introduce "circuit breakers" to stop trading in the event of a flash crash. BaFin has been given enhanced supervision and intervention powers; it is now able to request a description of algorithmic trading parameters and can prohibit the use of some of these strategies.

In other jurisdictions, HFT has been targeted through taxation. Under the Italian FTT, which came into force on March 2013, HFT transactions are subject to a 0.02% tax on the counter-value of orders automatically generated by an algorithm; this includes revocations or changes to the original order. It is still too early to determine the effect this tax has had on HFT.

The US regulatory focus has been two-pronged. The SEC's Quantitative Analytics Unit has teamed up with the FBI to investigate how firms use HFT strategies. The FBI explained that it is helping the regulator tackle the potential threat of market manipulation posed by new computer trading methods that have taken operations beyond the scope of traditional policing. The CFTC established a subcommittee of its Technology Advisory Committee to look at the risks posed by HFT. Opinion within the CFTC seems divided although it looks as though it will publish a paper on HFT in the near future.

In contrast, the UK government commissioned the Foresight Report into the Future of Computer Trading in Financial Markets, which was published in October 2012. The Foresight Report, which followed a two-year study led by HMT and DFBIS identified four specific benefits of HFT for markets: liquidity, reduced volatility, price discovery and reduced transaction costs.

The Australian Securities and Investments Commission (ASIC) conducted a six-month study into HFT, which was published in March 2013. The study found that while there were incidents of market manipulation involving layering and quote stuffing, fears over HFT appear to be exaggerated and it does not seem to be a key driver for changes seen in price formation, liquidity and execution costs.

The lack of consensus amongst regulators globally means that firms employing HFT strategies globally have to stay on top of the detail in all the jurisdictions where they are trading, and deal with compliance and reporting issues one country at time.

MiFID II

Although some member states, including the UK, question the need for HFT specific regulation, proposed MiFID II Article 17 addresses automated trading, including HFT. While the Level 1 text is not yet finalised, the latest Presidency compromise issued on 15 May 2013 may provide insight into the direction of travel:

  • HFT firms must be authorised and subject to regulatory supervision
  • Firms should have systems and risk controls in place to make sure trading systems are resilient and have capacity, and prevent the sending of erroneous orders
  • Firms should have measures in place to make sure that their trading systems cannot be used in a way that contravenes MAR
  • Firms engaging in automated trading should notify their national supervisor, which may require firms to provide details of their algorithmic trading strategies. Firms should keep adequate records so that this information can be provided to the regulator on request
  • Firms engaged in market-making should carry their market-making activities out continuously during a specified period of a trading venue's trading hours to provide liquidity on a regular and predictable basis to the trading venues
  • Regulated markets should be able to temporarily halt trading if a significant price movement in a financial instrument occurs over a short period, and should have systems in place to limit the ratio of unexecuted orders.

MiFID II will require ESMA to develop technical standards to implement rules on HFT. Those measures will complement action taken by ESMA in February 2012, when it published guidelines on systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities. The guidelines require firms to test and monitor algorithms, and to have procedures in place to minimise the risk that their automated trading activity gives rise to market abuse.

Implications of regulating HFT

Technology is a key driver of innovation in financial markets. At a time when the industry is faced with mounting constraints from regulation, advancements in technology are increasingly becoming a source of growth and development. Therefore regulators are presented with a tough challenge: maintain the integrity of markets while at the same time, not stifling advances in the development of markets. The divergent global regulatory responses to HFT have revealed a lack of consensus as to the way forward.

The HFT industry will be watching developments in MiFID II particularly closely over the coming months, but all investors have a stake in the outcome. ESMA will be given a significant degree of control over the fate of HFT in Europe as it develops technical standards. Onerous requirements under MiFID II, coupled with uncertainty over the FTT, could leave HFT firms operating in Europe seriously questioning the viability of their business models. Alternatively, an inadequate regulatory response risks leaving other investors without sufficient protection against market volatility and abuse from HFT.

In order to address these competing concerns, policy makers must determine where HFT presents genuinely new risks in need of new legislation, and where existing rules covering market abuse already apply to HFT. The challenge for regulators is then to keep pace with innovative financial markets, to monitor markets closely however rapidly they move, and to challenge trading activity which harms other market participants.

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