European regulators have conditionally settled on a final definition of high frequency trading, increasing momentum for tighter regulation of the controversial market.
The definition, contained in unpublished draft MiFID II text seen by IFR, describes high frequency trading as “the submission on average of at least 4 messages per second with respect to all instruments traded on a trading venue or at least 2 messages per second with respect to any single instrument traded on a trading venue”.
MiFID stands for the Markets in Financial Instruments Directive, while MiFID II is an effort to revise earlier rules to improve the functioning of financial markets in the aftermath of the financial crisis.
The use of messaging volumes as a parameter will come as a relief to many market participants more likely to be caught by alternative definitions being considered by regulators. Those included a direct approach, based on a firm’s primary business, and other definitions reflecting intra-day inventory management (flat positions throughout the day indicate HFT) or the lifetime of orders (less than 0.2 seconds implies HFT).
High frequency trading techniques comprise as much as half of all activity in European equity markets, depending on how they are defined, according to a European Securities and Markets Authority paper published in December.
“The four messages per second metric is more generous than many had expected”
The techniques lend themselves to manipulative strategies, Esma has said, including “spoofing”, “quote stuffing” and “layering”, the approach cited by US prosecutors in charges made last week against a London-based futures trader allegedly connected to the 2010 “flash crash” in US equities and futures markets. However, they also bring benefits in terms of bid offer spreads and liquidity.
Authorisation
The messaging volume-based definition of HFT will underpin rules to regulate algorithmic and high-frequency trading in MiFID II and the new European Market Abuse Regulation. MIFID II requires that firms using “high-frequency algorithmic trading techniques” must be authorised and meet a range of requirements in respect of record keeping, order transparency and trade quotes.
The favoured approach, set to be discussed at the next meeting of the Expert Group of the European Securities Committee, is relatively light-touch. In its December survey Esma identified 181 out of a total of 1,211 members of different venues as HFT firms using the direct approach. By contrast, the message frequency measure resulted in just 21 firms defined as HFT. Of those, five were (unnamed) investment banks.
Esma said that under the direct approach, HFT would account for 24% of value traded in European equities, while the lifetime of orders approach would lead to 43% of European equity market value traded being classified as HFT.
“The four messages per second metric is more generous than many had expected,” said a legal source with knowledge of the situation. “A lot of firms that would have been caught by other approaches will be breathing a sigh of relief.”
Under the message traffic approach, activity classified as HFT varies significantly based on the threshold value. For example, where the threshold is set at two messages per second for particular stocks, some 5% of value traded is classified as HFT, rising to 48% of value traded for one message every 10 seconds.
Latency arbitrage
One of the most widely discussed strategies used by high frequency traders is so-called latency arbitrage, which makes money from large buyside orders. In the US, orders must be routed to every exchange to find the best price, enabling high frequency trading firms to place waiting orders on exchanges to be hit by incoming buyside orders.
Having established the buyside price and size, the waiting order is then cancelled and the information used to place bids or offers on the same security at high speed across the market.
In Europe, there is no regulatory mandate to route orders, but there is a duty on brokers to provide best execution. Some investors are convinced that leaves them exposed to the same arbitrage techniques as seen in the US, with brokers following clear pre-defined routes to market.
“Four or five years ago we realised that the smart order logic being offered by brokers may be compromised by brokers who may have a preference for their certain venues,” said Simo Puhakka, chief executive officer at Pohjola Asset Management Execution Services.
“We wanted to avoid toxic flow and in the end we designed our own smart order router, with our own data centre, and the results very quickly started to be quite good.”
Pohjola now shared its router technology with 16 other buyside firms, Puhakka said.
