ESMA publishes a consultation paper (ESMA/2011/224) today setting out its proposals for detailed guide- lines for trading platforms, investment firms and competent authorities to address challenges of a highly automated trading environment, of which high frequency trading (HFT) is an important part. The guide- lines seek to clarify the obligations of trading platforms and investment firms under the existing EU legis- lative framework. ESMA believes that the proposed guidelines contribute to the efficiency, orderly func- tioning and resilience of trading in a highly automated environment.
Secondary trading in financial instruments carries a number of risks, such as operational, credit and market risks as well as risks of abusive behaviour that can threaten the regulatory objectives of investor protection, fair and orderly trading, efficient price formation, financial stability and prevention of behav- iour undermining market integrity. These risks are inherent to trading and also exist when trading is done on a person-to-person basis or over the telephone. However, in a highly automated trading environment, the organisational arrangements required by trading platforms and investment firms should be tailored to the scale, sophistication and speed of the trading activity that is now taking place and should keep up with the challenges posed to regulatory objectives.
Steven Maijoor, chair of ESMA, said:
“Clarification of the organisational arrangements which competent authorities can expect from regu- lated markets, multilateral trading facilities and investment firms to cope with the particular challenges of a highly automated trading environment is an essential step in providing a harmonised supervisory approach in this area. Technological innovation has enabled investors to monitor prices in real time and to submit orders electronically. It has also facilitated trading efficiencies, simplified settlement processes and created new business opportunities for investment firms. A common interpretation of the existing requirements in MiFID will ensure that safeguards in relation to electronic trading systems, fair and orderly trading, direct market access and sponsored access; as well as market abuse will be applied in a homogenous manner and that increased competition in a highly automated trading environment will not lead to an uneven playing field.”
The proposed guidelines are part of extensive work undertaken by ESMA in the area of micro-structural issues and highly automated trading. This includes, for instance, a review of academic literature on the effects of HFT; targeted fact-findings with trading platforms, HFT firms and investment firms providing direct market access/sponsored access; an inquiry with buy-side participants about the impact of HFT on market quality; a roundtable discussion with market participants; and the identification of issues related to the market micro-structure or highly automated trading which would need legislative amendments to be adequately addressed.
The proposals on the clarification of obligations of trading platforms and investment firms under the existing EU legislative framework published in ESMA’s consultation paper (CP) today, addresses broadly four areas. In each area, the guidelines cover separate standards for organisational requirements with respect to a highly automated trading environment for trading platforms on the one hand, and investment firms on the other. These can be summarised as follows:
1. Electronic trading systems
In complying with their overarching obligations in respect to their electronic trading systems, it is pro- posed that trading platforms should have regard to several key issues. These include:
- • clear and formalised procedures for the development, procurement and monitoring of electronic trading systems;
- • resilient and robust systems, well adapted to the business that takes place through them (including the flow of message traffic), and effective business continuity arrangements;
- • a testing phase prior to the electronic trading system or updates thereof being deployed;
- • staff with necessary up-to-date skills and expertise to run the electronic trading systems;
- • periodic review and evaluation of procedures and arrangements, including the electronic trading systems themselves, with some degree of independence;
- • adequate records, including, for example, information about key decisions, system properties, test-ing methodologies, test results and periodic reviews;
- • appropriate reporting to competent authorities of significant risks to the sound operation of the electronic trading systems.
Most of these points are also relevant to the electronic trading systems of investment firms. Main addi- tional guidelines relate to trading algorithms used by investment firms.
2. Fair and orderly trading
In the context of the challenges of trading in a highly automated environment, ESMA’s guidelines focus on the aspect of fair and orderly trading that relates to the controls that investment firms should have and that trading platforms need to impose on their members/participants and users.
The guidelines proposed for investment firms are to promote fair and orderly trading include organisa- tional requirements to deal with erroneous order entry, risk management and overriding pre-trade con- trols.
For trading platforms, the guidelines cover issues such as pre-trade controls, the possibility to limit the number of orders which each member/participant or user can send to the trading platform; conformance tests to ensure that members/participants’ or users’ IT systems are compatible with the trading platforms’ electronic trading systems; automatic mechanisms to constrain trading or to halt trading in a specific financial instrument or more widely in response to significant variations in price to prevent trading be- coming disorderly; undertaking adequate due diligence of the member/participant or user before accept- ing their market access and the ability to check their respective controls and arrangements afterwards; setting requirements governing the knowledge of employees of members/participants or users and keep- ing adequate records of their policies and procedures to ensure fair and orderly markets.
3. Preventing market abuse and in particular market manipulation
ESMA expects that trading platforms’ rules and procedures are designed to prevent, identify and report instances of possible market abuse and that they should at least include arrangements that are proportion- ate to the nature, size and scale of the business done through the trading platform. Furthermore, trading platforms need to monitor orders and transactions with the aim of flagging possible instances of conduct that might involve market abuse and in particular market manipulation for follow-up investigation. These systems will need to be subject to frequent review to ensure their continued adequacy in times of higher volumes of information. In addition, employing staff with appropriate knowledge about legislative prohibi- tions and trading strategies is vital to follow-up information provided by automatic alerts. The proposals would also require the reporting of possible instances of market abuse to competent authorities without delay. The trading platforms record keeping should also be of a high enough standard to allow for effective audit trails regarding how each alert is dealt with.
As for investment firms engaging in highly automated trading, the proposed guidelines stress that their policies and procedures should include similar arrangements for monitoring, staff and records. In relation to their obligation to report suspicious transactions, the guidelines stress that, given the nature of highly automated trading, these reports should be extended to orders entered, modified or cancelled, even if they did not lead to a transaction.
4. Direct market access and sponsored access
The increasing sophistication of trading technologies enables firms to access markets and place orders with greater independence, speed and reduced cost. Direct market access (DMA) and sponsored access (SA) offer market participants that are not members/participants or users of regulated markets (RMs) or multilateral trading facilities (MTFs), a more direct or independent route to the market than conventional trading through an intermediary, and in doing so, provide latency advantages and trading anonymity.
However, there are certain risks arising from DMA/SA arrangements. These include the risks that the client’s trading breaches a trading platform’s operating rules and the DMA/SA provider’s respective re- sponsibility; an increased risk that market abuse be disguised by ‘hiding’ behind an intermediary’s mem- ber identification; credit and reputational risk to the investment firm; as well as, a risk of a market-wide disruption depending on the scale of the business undertaken by the DMA/SA client.
The proposed guidelines therefore cover organisational requirements for investment firms and trading platforms targeted at these kinds of risks. Generally, the DMA/SA provider firms should be mindful of their responsibility for all trades executed under their market participant IDs. This responsibility should govern their approach towards assessing potential DMA/SA clients and the monitoring of their trading activity. For a robust framework to mitigate the risks, controls need to operate on a pre-trade and post- trade basis. And of course, risk controls needs to be monitored on an ongoing basis.
On this basis, investment firms offering DMA/SA services would therefore, for example, need to assess prospective DMA/SA clients in accordance with predefined criteria, taking into account the potential impact of the DMA/SA client’s trading strategy, the client’s historical patterns of trading on the relevant trading platforms and the wider market, and its disciplinary history with competent authorities and trad- ing platforms.
Under the proposed guidelines, they would also need to apply pre-trade controls to the trading of DMA/SA clients which stop automatically any order from a DMA/SA client either compromising the DMA/SA provider firm’s risk appetite or the credit thresholds of client. Whereas in the case of DMA this can be done at the firm level when the order passes through its systems, for SA this would need to be done at the trad- ing platform level. It is therefore important that DMA/SA firms, wherever they source their pre-trade controls, be it a third party vendor, their own proprietary controls, or controls offered by the trading platform, have the in-built and automatic ability to cancel a trade, should the trade pose a risk. On a post- trade level, the guidelines propose that a DMA/SA provider firms should at least monitor trades using real-time copied feeds of their DMA/SA clients’ activities and using client IDs to monitor and review their DMA/SA clients’ trading activity. DMA/SA firms should also have the post-trade measure to terminate a DMA/SA client’s access to the order book.
Corresponding to DMA/SA providers’ obligations, trading platforms should, for example, establish clear agreements about the responsibility of the DMA/SA provider for all trades under its member/participant ID, and require that the firm providing DMA/SA services have adequate systems to minimise the risks of their clients disrupting orderly trading or participating in market abuse activities. However, where neces- sary, trading platforms should also be able to carry out a review of members’/participants’ or users’ inter- nal risk control systems. They should also retain the right to decide who is able to access their market. In the case of prospective SA clients connecting directly to the trading platform without passing their orders through the sponsoring firm’s order management systems, a trading platform should refuse or withdraw access if it is not satisfied that the SA client acts in conformity with the rules and procedures for fair and orderly trading. They should also have the ability to distinguish and stop orders from persons trading through SA separately from their members by assigning unique customer IDs to clients that are accessing their market through SA.
In addition to these four areas covered by the guidelines, ESMA would also like to draw stakeholders’ attention to the information included in the annexes to the CP which cover, amongst other things, a cost- benefit analysis of the draft guidelines, a review of academic evidence on the effects of high frequency trading and algorithmic trading on market quality, as well as summaries of the responses to CESR’s Call for Evidence on micro-structural issues and of the results of a targeted fact-finding as far as they relate to the topics covered by the CP.
ESMA is conscious of the fact that the matters covered in this consultation paper are also of interest to regulatory authorities outside the EEA. ESMA believes it is desirable to achieve a broad consistency of approach to these issues across different jurisdictions given the links between the financial markets of the EEA and the rest of the world. In the draft guidelines, ESMA has therefore sought to take account of devel- opments in countries outside the EEA.
Next steps
In light of the comments received from respondents by the deadline of 3 October 2011, ESMA expects to publish final guidelines at the end of 2011.
