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MiFID II and Algorithmic Trading: What You Need to Know Now

Traders Magazine Online News, August 3, 2017

Andrew Gibbins

This is the second in a series of blog posts on MiFID II (Markets in Financial Instruments Directive II). If you missed the first post, see MiFID II: How Did We Get Here and What Does it Mean? Continuing to review MiFID II, algorithms form the bedrock of modern electronic trading and, unsurprisingly, are of significance in the regulation. This post introduces an overview of the focus of the regulation and its concepts specific to algorithmic trading.

Trading Technologies provides a sophisticated and industry-tested product suite of automated order types and tools including TT’s Autospreader®, ADL®, APIs and synthetic order types, such as OCOs and Icebergs. These order types are in scope under MiFID II. Having reviewed the regulation, it is clear that the bar has been deliberately set at a level to capture a greater swath of automated order types in order to prevent systemic risk and address G20 concerns. Read on for an overview.

ALGORITHMIC SAFEGUARDS: DEFINING BEAUTY, PREVENTING THE BEAST

Regulatory Technical Standards (RTS) 6 and 7 of MiFID II stipulate an array of measures to introduce and standardize the systems and risk controls pertinent to algorithmic trading and to the provision of direct electronic access and due diligence. These measures apply to investment firms, including general clearing members, and trading venues. The nature, scale and complexity of the business model are cited for consideration when addressing efficiency, resilience and adequate capacity.

WHAT IS “ALGORITHMIC TRADING TECHNIQUE?”

Algorithmic trading is introduced and defined in several key MiFID II sources as comprising “trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as [1], [2]:

  • 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 and,
  • does not include any system that is only used for the purpose of routing orders to one or more trading venues or
  • for the purposes of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions.”

MiFID II Delegated Regulation stipulates that algorithmic trading should refer to the automated optimization of order execution processes, in addition to the automatic generation of orders. This includes smart order routers (SORs) only in conjunction with the use of algorithms that determine parameters of the order beyond venue identification. It does not include automated order routers (AORs) where they only determine the venue without changing any other parameter of the order[3].

Utilization of such orders types, whether developed in-house or by a third-party, will warrant greater understanding by investment firms, who will be responsible for matters including prior testing, controlled deployment of algorithms to users, and the marketplace (access) and subsequent material changes. Firms will be required to ensure that the time of a material change, its nature, author and approver are recorded.

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