MiFID IIKey Points MiFID II introduces closer regulation of algorithmic and high-frequency trading Algorithmic traders engaging in market making activity will be subject tospecific requirements under MiFID II Firms providing direct electronic access must have effective systems andcontrols Firms that are involved in algorithmic trading must issue a notification to theirnational regulators General clearing members will be subject to systems and controlsrequirements, and will be required to have in place a written agreement withtrading venues2016Algorithmic and highfrequency trading forinvestment firms
MiFID II 7 January 2016This note contains matters relating to the impact ofMiFID II on investment firms that engage in algorithmicand high-frequency trading. For the impact of MiFID IIon trading venues that permit algorithmic and highfrequency trading on their systems, please see ourseparate briefing note on the Market Infrastructure andTrading Venues.Definitions and scopeMiFID II introduces the concept of algorithmic tradingand, as a subset of that, high frequency algorithmictrading ("HFT"). MiFID II seeks to ensure that all HFTtrading firms are authorised as investment firms.Algorithmic trading is defined in the MiFID II Directiveas:1 Under MiFID I, persons engaging in algorithmic tradingon their own account could take advantage of3exemptions for persons dealing on own account.However, MiFID II will remove the availability of thisexemption where a person engages in HFT techniques.The consequence of this is that, unless anotherexemption applies, the HFT trader will need to become4authorised.ESMA was invited to provide technical advice on thedistinction between algorithmic trading and HFT, and toensure a uniform application of the authorisationrequirements. ESMA's Technical Advice of December2014 makes the following clarifications to the scope ofalgorithmic trading:"trading in financial instruments where a computeralgorithm automatically determines individualparameters of orders such as whether to initiate theorder, the timing, price or quantity of the order or how tomanage the order after its submission, with limited or nohuman intervention, and does not include any systemthat is only used for the purpose of routing orders toone or more trading venues or for the processing oforders involving no determination of any tradingparameters or for the confirmation of orders or the post1trade processing of executed transactions)."HFT is also defined in the Directive. According to theDirective, a "high-frequency algorithmic tradingtechnique" is a form of algorithmic trading where atrading system analysis data from the market at highspeed and then sends or updates large numbers oforders within a short time frame as a result of thatanalysis. Under the MiFID II definition it is characterisedby: infrastructure intended to minimise network andother types of latencies, including at least oneof the following facilities for algorithmic orderentry: co-location, proximity hosting or highspeed direct electronic access; system-determination of order initiation,generation, routing or execution without humanintervention for individual trades or orders; andArticle 4(1)(39), MiFID II Directive. automated trading decisions and theoptimisation of order execution processes byautomated means are included in the definition; it will be considered algorithmic trading if thesystem makes independent decisions at anystage of the processes on either initiating,generating, routing or executing orders(including quotes); the definition excludes automated order routersthat only determine the venue(s) where theorder should be submitted without changing5any other parameters of the order.For the purposes of distinguishing HFT, ESMA'sTechnical Advice recommends one of three measuresfor the identification of high message intra-day ratesshould be applied to proprietary orders in liquidinstruments: Absolute threshold per instrument: the average(within a rolling 12 months) number ofmessages sent per trading day to any singleliquid instrument traded on a venue is above 2messages per second;2Article 4(1)(40), MiFID II Directive.3Article 2(1)(d), MiFID I Directive.4Article 2(1)(d)(iii), MiFID II Directive.51high message intraday rates which constitute2orders, quotes or cancellations.ESMA, Final Report: Technical Advice to the Commission on MiFIDII and MiFIR, 19 December 2014 (ESMA/2014/1569) (the "TechnicalAdvice"), chapter 5.1, p. 338.
MiFID II 7 January 2016 2in line with a particular investment strategymore than a certain number of times.Absolute threshold per trading venue and perinstrument: submission of at least 4 messagesper second with respect to all instrumentsacross a venue or 2 messages per secondtraded with respect to any single instrumenttraded on a venue;Relative threshold: the median daily lifetime ofits modified or cancelled orders falls under athreshold below the median daily lifetime of allthe modified or cancelled orders submitted to a6given trading venue, on an annual basis.Although this represents a change to ESMA's originalproposal, respondents generally considered thesenumbers to be low volume.Systems and controls requirementsUnder MiFID II, firms engaging in algorithmic tradingmust have in place effective and resilient systems, aswell as appropriate risk controls. Firms must ensurethese systems are tested, and that they have in placebusiness continuity arrangements. There must beappropriate order limits to prevent erroneous orders andorders that could create a disorderly market from being7entered.Monitoring of trading activity with real-timealerts identifying signs of disorderly trading orbreaches of pre-trade limits. Testing of trading systems and algorithms,including, for example, testing of the ability ofthe algorithm or strategy to work effectively instressed market conditions ("stress testing"). Segregation of trading, middle office and backoffice staff. Minimum requirements for business continuity9arrangements.ESMA has made a number of changes andclarifications to these requirements in its recent RTSrelease compared with its earlier Consultation Paper in10December 2014. For example, ESMA has:Under MiFID II, firms must also have controls in placewhich automatically cancel any orders that the relevanttrader is not permitted to make or that exceed the firm'srisk thresholds. Firms must also monitor their systemsand have in place procedures to identify thosealgorithms that could cause a disorderly market. As partof this, the firm must have the capacity to cancel alloutstanding orders at all trading venues (the "killswitch").In September 2015, ESMA published its final regulatorytechnical standards ("RTS") in respect of these8requirements. The RTS sets out detailed requirementsin relation to, for example: Pre-trade controls (i.e. controls that shouldoperate before an instruction is submitted to atrading venue), such as automatic executionthrottles that prevent trading being undertaken allowed for a firm's compliance function tooperate the "kill switch" itself; replaced specific training requirements onalgorithmic training with a more general focuson knowledge and competence; maintained its previous proposal for thesegregation of trading functions, middle officeand back office, but clarified that this is inrelation to a firm’s governance of its algorithmictrading systems; clarified that a number of these requirements(such as some of the testing requirements) donot apply to pure investment decisionalgorithms which do not make order executiondecisions; clarified that the requirement to segregatetesting and production environments does notrequire duplicate physical systems orinfrastructures;96ESMA, Technical Advice, chapter 5.1, p. 338.7Article 17(1), MiFID II Directive.8In accordance with Article 17(7), MiFID II Directive.RTS 6 in ESMA, Regulatory technical and implementing standards:Annex I, MiFID II/MiFIR, 28 September 2015. See also ESMA, FinalReport, Draft regulatory technical and implementing standards onMiFID II/MiFIR (the "Final Report"), 28 September 2015.10ESMA, Consultation Paper, Regulatory technical standards onMiFID II/MiFIR, 19 December 2014.
MiFID II 7 January 2016 made amendments to the stress testingobligations that firms have, including limiting thenumber of mandatory test scenarios to two; made changes to the pre-trade controlframework, including reducing the number ofmandatory pre-trade controls prescribed; and made changes to the business continuityrequirements to add flexibility. For example, theprescribed list of disruptive scenarios initiallyprovided has been replaced by a generalrequirement to have appropriate businesscontinuity arrangements in place. ESMA hasalso clarified that it no longer requires all firmsto resume trading after an event —there maybe scope for firms to wind down theiroperations instead.Market making strategyMiFID II imposes obligations on algorithmic traderswhen they pursue a market making strategy. A personengaged in algorithmic trading will be considered topursue a market making strategy when its strategy(when dealing on its own account) involves the firm,simultaneous posting of two-way quotes of comparablesize and at competitive prices relating to one or more11financial instruments on a regular and frequent basis.A person pursuing such a strategy must:(a) except under exceptional circumstances, carry outthis market making continuously during a specifiedproportion of the trading venue’s trading hours;(b) enter into a binding written agreement with thetrading venue specifying its market makingobligations; and(c) have in place systems and controls to ensure its12compliance with the agreement in (b).Further requirements have been set out in RTS 8 of13ESMA's September 2015 RTS release in relation towhen an investment firm will be deemed to pursue amarket making strategy, minimum obligations to be11Article 17(4), MiFID II Directive.12Article 17(3), MiFID II Directive.13ESMA, Regulatory technical and implementing standards: Annex I,MiFID II/MiFIR, 28 September 2015. See also ESMA, Final Report,28 September 2015.3specified in the agreement, and detail on the"exceptional circumstances" in (a). ESMA made anumber of changes to its approach compared with itsDecember 2014 Consultation Paper. In particular,ESMA changed its view on when an investment firm willbe considered to be pursuing a market making strategy,which triggers the requirement to sign a market makingagreement.Direct electronic accessMiFID II seeks to ban the provision of direct electronicaccess to markets by investment firms for their clientswhere such access is not subject to proper systems and14controls.Under MiFID II, direct electronic access means:"an arrangement where a member or participant orclient of a trading venue permits a person to use itstrading code so the person can electronically transmitorders relating to a financial instrument directly to thetrading venue and includes arrangements which involvethe use by a person of the infrastructure of the memberor participant or client, or any connecting systemprovided by the member or participant or client, totransmit the orders (direct market access) andarrangements where such an infrastructure is not used15by a person (sponsored access)."Under such arrangements, clients are permitted to enterorders on an intermediary's internal electronic system,which then automatically places an order on a tradingplatform using the intermediary's ID or the intermediaryallows clients to transmit orders electronically anddirectly to the trading platform using the intermediary'sID without being routed through the intermediary'sinternal electronic systems.The own account dealing exemption is removed for16persons who have direct electronic access.ESMA was invited to provide technical advice to clarifythe definition so as to capture all types of arrangementsthat might be covered by this definition. The ESMATechnical Advice makes the following clarifications forthe purposes of direct electronic access:14Article 17(5), MiFID II Directive.15Article 4(1)(41), MiFID II Directive.16Article 2(1)(d)(iii), MiFID II Directive.
MiFID II 7 January 2016 4is a risk that a trade could contribute to adisorderly market; andthe key characteristic of direct electronic accessis the ability to exercise discretion regarding theexact fraction of a second of order entry andthe lifetime of the orders within that timeframe;where a client order is effectively intermediatedby the member or participant of the tradingvenue or a system that simply allows clients totransmit orders to an investment firm in anelectronic form, this would be outside the scopeof direct electronic access (provided the clientdoes not have discretion as to the exact timingof the book entry or an ability to react to marketdata);Smart Order Routing ("SOR") is a type ofalgorithm concerned with the execution of anorder, and not where the order should beexecuted. The algorithm will split a large orderinto smaller orders. SORs come within thedefinition of "algorithm trading". If client ordersare routed via a SOR that is embedded in themarket member/participant's routing systemand not in the client's order generating systemthen this will be outside the scope of directelectronic access as the client does not havethe requisite control over the time of submissionof the order and its lifetime;Automated Order Routing or ("AOR") is asystem used by an intermediary to allow aclient to place an order on the market under theclient's ID. The use of the ID allows theintermediary to monitor and stop any trades ifnecessary. AOR does not necessarily fall in orout of the definition of direct electronic accesshowever, if the client does not have discretionas to how the order is executed, it will not comewithin the definition of direct electronic17access. monitoring of client's trading activity on a realtime basis to allow the trading venue to adapt18such pre-trade controls where necessary.The September 2015 RTS release includesrequirements in respect of systems and controls andparticularly, due diligence of direct electronic accessclients, on-going review of direct electronic access19clients, and pre- and post-trade controls. A personproviding sponsored access must have equivalentcontrols in relation to sponsored access users.ESMA recommends that unique identification numbers20are assigned to all users of direct electronic access, toallow a firm to identify a user, and subsequentlysuspend or terminate the user's direct electronic accesswhere there is a risk of disorderly trading. This shouldthen be reported to the relevant national competentauthority ("NCA").Member state notificationA firm engaging in algorithmic trading must notify itsNCA. It must keep records of all key compliance andrisk controls it has in place, along with its algorithmictrading strategies and any relevant limits. It mustprovide such information and records to its NCA on21request.A person providing direct electronic access must notifyits NCA, and where applicable notify its trading venue. Itmust keep records all key compliance and risk controlsit has in place and provide such information and records22to its NCA on request.General clearing membersA firm that acts as a general clearing member must:The new MiFID II system and controls requirements forproviders of direct electronic access are as follows: 17a proper assessment of the suitability of allusers; pre-set trading and credit thresholds; pre-trade controls in place to allow theautomatic cancellation of a trade, where there18Article 17(5), MiFID II Directive; and RTS 13 in ESMA, ConsultationPaper, 19 December 2014.19RTS 6 in ESMA, Regulatory technical and implementing standards:Annex I, MiFID II/MiFIR, 28 September 2015.20ESMA, Technical Advice, chapter 5.2, pp. 343-4.RTS 6 in ESMA, Regulatory technical and implementing standards:Annex I, MiFID II/MiFIR, 28 September 2015.21Article 17(2), MiFID II Directive.22Article 17(5), MiFID II Directive.
MiFID II 7 January 2016 enter into a written agreement with the tradingvenue which specifies its market makingobligations; and have in place systems and controls to ensureits services are only applied to suitable23persons.The September 2015 RTS release includesrequirements for firms acting as general clearingmembers in respect of systems and controls,determination of suitable persons, position limits, and24client disclosures.Timescales for implementationThe MiFID II Directive and MiFIR came into force on 3July 2014. Most of their provisions are currently statedto come into effect in member states from 3 January2017, with Member states having until July 2016 totranspose the MiFID II Directive into national law.However, following discussions between ESMA and theEuropean institutions, it is now expected that theimplementation of MiFID II will be delayed until January2018.ESMA submitted draft technical standards to theCommission on 28 September 2015. In principle, theCommission has had three months to consider whetherto endorse the technical standards (i.e. by 28December 2015). However, in the context of ongoinguncertainty regarding the legislative timetable, theCommission has not met this deadline.The European Commission is also drafting delegatedacts on the basis of the Technical Advice received fromESMA in December 2014.2324Article 17(6), MiFID II Directive.RTS 6 in ESMA, Regulatory technical and implementing standards:Annex I, MiFID II/MiFIR, 28 September 2015.5
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Jan 07, 2016 · to resume trading after an event —there may be scope for firms to wind down their operations instead. Market making strategy MiFID II imposes obligations on algorithmic traders when they pursue a market making strategy. A person engaged in algorithmic trading will be consid