Since the flash crash in 2010, we have witnessed a stream of market events which have impacted the reputation, profitability and at times the existence of several market participants. This has fuelled the concerns of politicians and regulators alike to the extent that risks associated with automated trading systems could cause a catastrophic markets related event.
Whilst MiFID encouraged competition and led to increased market fragmentation, we can expect a step change under MiFID2 as the number and variety of execution venues will substantially increase. In an attempt to closely monitor and control electronic trading, MiFIR will introduce provisions to ensure that High Frequency Trading (HFT) does not have an adverse effect on market quality or integrity, including:
- Requiring HFT firms, engaging in proprietary trading, to become authorised
- Introducing new systems and control requirements on the use of algorithms
- Requiring HFT firms (who use market making strategies) to enter into market making agreements
- Trading venues will set limits on ‘order to trade’ ratios
- Minimum tick sizes will be set
- Venue pricing can be used to penalise excessive order messaging
In relation to algorithmic trading systems, MiFIR will introduce a requirement to have an annual systems review to assess and clarify senior management’s understanding of the risks and also the setting and adjustment of the firm’s risk appetite. Firms will be required to ensure that employees act in line with that appetite and are suitability trained on order entry procedures and controls and the prevention of market abuse. Staff must also be fully aware of when they can and cannot release orders into the market whilst also having an appreciation of what constitutes disorderly trading conditions. This is a complex area to navigate and one where Duff & Phelps’ Kinetic Partners division has been actively involved in providing guidance and training to firms.
We have seen the pre-trade controls used by firms and venues developing significantly over the last few years for example with the introduction of circuit breakers which can be triggered in a variety of circumstances.
It is important that firms and venues conduct scenario based tests (in a non-production environment) which attempt to break these controls; thus creating a disorderly market scenario. Firms have asked us to help them think through the design, development and deployment cycle and associated controls as this is absolutely critical. We work together to prove that they cannot create a price-spike beyond reasonable parameters and that orders are suspended as expected under such circumstances. We develop tests to incorporate extreme scenarios, oversee market testing and help fine-tune the pre-trade control parameters.
European Securities and Markets Authority (ESMA) has emphasised that firms need automation for monitoring of algo activity and Direct Electronic Access (DEA) providers must monitor their credit and market risk on a real-time basis and suspend orders where necessary. In relation to market abuse, there is also an ongoing expectation for firms to monitor order activity for offences such as spoofing, quote stuffing, momentum ignition and smoking, the latter being a more recently defined type of market abuse.
The creation and ongoing maintenance of a Market Abuse Risk Assessment across all asset classes, coupled with the development of a market impact test pack are valuable tools required to mitigate the risk of a firm either creating a disorderly market or inadvertently facilitating market abuse. This is a good “insurance policy” in our experience.