Algorithmic Trading and HFT: MiFID II Definition and Regulatory Updates

Algorithmic Trading and HFT Definition

prof. Paola Lucantoni LUISSAlgorithmic Trading and HFT MiFID II definition (art. 4(1)(39) "algorithmic trading' means trading in financial instruments where a computer algorithm 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.

What is NOT considered algorithmic trading?

It does not include:

• Systems only used to route orders to venues,
• Systems used only for order confirmation or post-trade processing,
• .Systems that do not determine any trading parameters. No human intervention

Algorithmic Trading Evolution

Before Algorithmic Trading

LUISSAlgorithmic Trading and HFT Before Broker

• Phone order
• Execution
• Order placed to the floor Client Market HUVHS

After Algorithmic Trading

LUISSAlgorithmic Trading and HFT After Broker

• Phone / internet order
• Automatic execution
• Interaction with order book Client Market

High-Frequency Algorithmic Trading Technique

LUISSAlgorithmic Trading and HFT HFT is one kind of Algo trading. According to MiFID II definition (art. 4(1)(40) high-frequency algorithmic trading technique' means an algorithmic trading technique characterised by:

(a) infrastructure intended to minimise network and other types of latencies. Includes advanced technology such as: Co-location (servers placed near exchange servers), Proximity hosting (hosting in the same data center as the market), High-speed direct electronic access (e.g., Direct Market Access - DMA, Sponsored Access).

(b) Fully automated decision-making The algorithm controls every stage of the order process: initiation, generation, routing or execution without human intervention for individual trades or orders; and

(c) High message frequency Extremely high volume of: orders, quotes, cancellations per day. Exploits (sfrutta) tiny price differences in very short timeframes.

HFT Infrastructure and Benefits

LUISSAlgorithmic Trading and HFT I. HFT is all about infrastructure:

I. Proximity hosting (the closer, the better) co-location

II. Direct Electronic Access :

I. Direct Market Access

II. Sponsored access Reduced Latency Faster execution Increased trading volumes = Profits

HFT Strategies

LUISSAlgorithmic Trading and HFT HFT Strategies

• Momentum strategy: short term orders before large orders are placed
• Latency arbitrage: orders are placed quickly to take advantage of market fluctuations
• Cross market arbitrage: short term price discrepancies of stocks in different markets are utilized for quick purchases and sales
• Market making strategies: executed trades ensuring liquidity - small profits for each trade + liquidity rebates

Potential Risks of HFT

LUISSAlgorithmic Trading and HFT Potential risks

• Systemic risk \ Market stability
• Computing error (rogue algo)
• Market Quality and Market Integrity
• HFT might increase volatility of the market
• Issues with price discovery (determinazione dei prezzi)
• Predatory practices
• Front running order anticipation *[ What is the "level playing field"? It's the idea that all market participants - big or small - should have equal access to information, speed, and trading opportunities. A threat to the level playing field principle? 1 4 9 8 7 0 LUISS While HFT adds liquidity and may reduce spreads, it also raises ethical and regulatory concerns about market fairness and access inequality.

Potential Benefits of HFT

Algorithmic Trading and HFT Potential benefits Increased liquidity and superior intermediation Increased market efficiency and market quality

Regulatory Interventions for Algorithmic Trading

LUISSAlgorithmic Trading and HFT Regulatory interventions Spot measures were used in the MiFID I \ MAD enviroment MiFID IIMiFIR and MAR provide a more comprehensive set of rules, targeted to AlgoT/HFT firms, investment firms that provide DMA(Direct Market Access) /SA (Sponsored Access) and trading platforms Generally speaking, applicable rules dictate:

• Organisational requirements (including rules on resilience of trading venues)
• Transparency\notification duties (obblighi)

Risk Controls for Algorithmic Trading Firms

LUISSAlgorithmic Trading and HFT General overview - risk controls A firm engaging in algorithmic trading will be required to have in place effective systems and risk controls to ensure its trading systems are resilient and have enough capacity, are subject to appropriate thresholds and limits which prevent sending erroneous orders, do not function in a way that contributes to a disorderly market and cannot be used for any purpose that is contrary to the rules of a trading venue to which it is connected. Firms must have effective business continuity arrangements to deal (per far fronte) with any system failure and ensure their systems are tested and monitored. The organisational requirements for different types of firm will be further specified in regulatory technical standards.

Trading Venue Requirements for Algorithmic Trading

LUISSAlgorithmic Trading and HFT Trading venues will also be required to have systems to ensure that algorithmic trading cannot create or contribute to disorderly trading on the market and to manage any such conditions that do arise. These will include systems to limit the ratio of unexecuted orders to transactions(Prevents abusive strategies like quote stuffing) (flooding the market with fake orders), slow down order flow(trading activity) and regulate minimum tick sizes (Ensure minimum price increments to reduce excessive micro-trading). Trading venues will be required

• to provide facilities for their members to test algorithms.
• to be able to identify orders generated by algorithmic trading, different algorithms used and the persons initiating the orders.

Market Making Strategy Requirements

LUISSAlgorithmic Trading and HFT To address concern on market disruption due by AT, MiFID II requires a firm that engages in algorithmic trading to pursue a market making strategy to:

• carry on its market making activity continuously during a specified proportion of the trading venue's trading day, except under exceptional circumstances;
• enter into a written agreement with the trading venue stating their market making obligations; and
• have in place effective systems and controls to ensure that it fulfils garantire l'adempimento) its obligations under the agreement Goal: Ensure that algorithmic traders who place frequent orders also support market liquidity, rather than just extract profits from others' activity.

Market Making Definition and Obligations

LUISSAlgorithmic Trading and HFT Market Making A firm is pursuing a market making strategy when, as a member of a trading venue, its strategy, when dealing on own account (in caso di negoziaz. Per conto prorpio), involves posting firm, simultaneous two way quotes: It posts both buy and sell prices (firm, simultaneous quotes), On one or more financial instruments, Either on one trading venue or across multiple, on a regular and frequent basis. The obligation to enter into agreements with firms pursuing market making activity is also imposed on trading venues. They must have schemes in place to ensure a sufficient number of firms enter into such agreements which require them to post firm quotes at competitive prices, providing liquidity to the market on a regular and predictable basis, where this is appropriate to the nature and scale of trading on that market.

Direct Electronic Access (DEA) Controls

LUISSAlgorithmic Trading and HFT DEA / SA (Direct Electronic Access) - DEA allows a client to send orders directly to a trading venue using a broker's infrastructure, without manual handling by the broker. A firm providing direct electronic access to a trading venue must have effective systems and controls in place to ensure:

• Proper (corretta) assessment (valutazione) and review of the suitability of clients using the service;
• that clients using the service cannot exceed any pre-set trading and credit thresholds;
• that trading by clients using the service is properly monitored; and
• that appropriate risk controls prevent trading that may create risks to the firm itself or that could create or contribute to a disorderly market.

DEA / SA Continued

LUISSAlgorithmic Trading and HFT DEA / SA (cont'd) Direct electronic access without such controls is prohibited and the firm is required to ensure that clients using direct electronic access comply with MiFID II and the rules of the trading venue. It must also monitor the clients to identify suspected market abuse or disorderly trading and report to the Member State competent authority. Additionally, the firm must have in place an agreement with its client setting out (stabilendo) the respective rights and obligations of the client.

Notification Obligations for Algorithmic Trading

LUISSAlgorithmic Trading and HFT Notification obligations A firm engaging in algorithmic trading or providing direct electronic access must notify its Member State competent authority and that of the trading venue of which it is a member.

• The firm's home Member State competent authority may, at any time, require the firm to provide details of the systems and controls it has in place and, in relation to algorithmic trading, a description of the nature of its strategies.
• This information can be shared with the Member State competent authority of the trading venue.
• The firm must also keep records to enable the Member State competent authority to monitor its compliance with these requirements.

Notification Obligations Continued

LUISSAlgorithmic Trading and HFT Notification obligations (cont'd) Where an investment decision is made by an algorithm, that algorithm must be identified in the transaction report sent to the home Member State competent authority. The method of identifying an algorithm is be set in regulatory technical standards, for which principals rather than setting prescriptive rules for identification are defined. The responsibility for interpreting those principals would sit with the investment firm.

Trading Venues Systems and Procedures

LUISSAlgorithmic Trading and HFT Trading venues Trading venues are required to have in place effective systems, procedures and arrangements to ensure their systems are resilient and are capable of dealing with peak order and message volumes, ensure orderly trading and are fully tested and subject to effective business continuity arrangements. Trading venues must also ensure they are able to reject orders that exceed pre-determined volume and price thresholds or that are clearly erroneous. There are also requirements in relation to tick sizes and synchronisation of clocks. LUISS