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by Kiki Pentheroudaki
MiFID II is intended to regulate the use of automated trading to ensure a level-playing field for all market participants. In a two-part overview we will provide you with insight into how regulators are thinking. Part one focuses on the history of automated trading and MiFID’s proposals around market-making for high-frequency traders.
Automated or algorithmic trading is used by a wide range of market participants. Profits from high-speed trading in American stocks were ca. $1.25 billion in 2012, 74% lower than the peak of about $4.9 billion in 2009, according to estimates from brokerage firm Rosenblatt Securities.
According to the Committee of European Securities Regulators (CESR) high frequency trading (HFT) accounts for up to 40% of total share trading in the EU. Studies suggest that HFT using market making and arbitrage strategies has added liquidity to the market, reduced spreads and helped align prices across markets.
On the other hand, there is evidence that the average transaction size has decreased, which makes it difficult for institutional investors to execute large orders. HFT is also linked with the increased use of dark liquidity – i.e. any pool of liquidity, which is not pre-trade transparent such as broker crossing networks and dark pools. Perhaps the most significant new risk arises through the misuse of algorithms (rogue or badly tested algorithms) posing a threat to the orderly functioning of markets in certain circumstances.
MiFID II aims to rectify some of these assumed irregularities by introducing a number of regulatory measures:
The European Commission’s MiFID consultation paper requires operators of algorithmic trading strategies to “post firm quotes at competitive prices with the result of providing liquidity on a regular and ongoing basis to trading venues at all times, regardless of prevailing market conditions”.
Continuously posting firm quotes can come in two different guises:
The impact of this market-making requirement will critically depend on how the requirement to ‘continually post firm quotes at competitive prices is interpreted. There will be significant additional risk applied to automated trading if the requirement is interpreted to mean that at all times the market is open, and that every algorithmic trader has to offer to buy and sell a security across a spread that reflects the usual spread for that security.
The push for transparency remains in full force, yet some market participants have questioned the introduction of market making obligations on the grounds that these may cause market makers to quit the market entirely or perhaps transition into other products such as derivatives or bonds. The legislative process is approaching the home stretch and this area will be put under more scrutiny going forward.
Next week’s part two will delve into more regulatory requirements such as authorisation, minimum resting times and the impact on dark pools.
This content is provided by an external author without editing by Finextra. It expresses the views and opinions of the author.
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