Algo trading has been on a constant rise over the past few years. With many platforms selling algorithms and programs that place trades automatically, the job has surely become a lot easier for traders. Prior to 2007, national stock exchanges had a monopoly in equity. But in 2007, the Markets in Financial Instruments Directive (MiFID) opened the market to competition by other platforms. This opened the avenues for smart order routers and dark pool algorithms in this fragmented market structure. As a result, more complex benchmark algorithms were introduced, and opportunities for more high-frequency trading came to the fore. As algo trading became popular, the MiFID II introduced further compliance and operational requirements for all algo platforms. These new regulations have been in force since January 2018.

Very recently on 28 September 2021, the European Securities and Markets Authority (ESMA) has published the MiFID II/MiFIR review report to highlight issues and recommend improvement in algo trading. This comes as a means to contemplate the various risk involved in the increased use of technology in trading. These risks include the generation of duplicate or erroneous orders, overreaction to market events that aggravate volatility in the market or market abuse. The review tries to identify potential risks of malfunctioning in algorithmic trading platforms that may create disorder in the market.

The ESMA report, however, concluded that no significant fundamental issues emerged during the review, meaning that MiFID II has delivered what it promised to in terms of the algorithmic trading regime. ESMA did recommend some improvements to make the regime simpler and much more efficient, though. The report also identified a few issues that need to be followed up. One of these issues is regarding the application of algo trading and high-frequency trading rules to direct electronic access and third-country algorithmic trading firms that deployed their strategies on EU trading venues. Another issue that the ESMA identified is related to the MiFID II provisions on tick size and market-making.

Impact of Brexit

Markets Media spoke to Martin Appiah, the director of regulatory affairs at Eventus Systems, to get his views on the ESMA report. Martin Appiah agreed that there were no major surprises for them but some significant material changes were expected after the review. He highlighted the impact that Brexit, or UK’s departure from the EU, may have on this whole matter.

He reminded that as a result of Brexit the relationship between the UK and the European Union has changed. The UK is now considered a third country like others, in the EU.

Appiah elaborated that many non-EU affiliates of the same group have been using direct electronic access (DEA) from the UK to access the EU markets, after Brexit. The ESMA recognizes and acknowledges the new financial paradigm that has arisen from Brexit and how it can bring several competitive advantages for a third country, including the UK, in certain areas. But it is also worth noting that ESMA made it clear in the report that they will be taking initiatives to ensure judicial use of DEA. The ESMA plans to review the responsibilities of all DEA users and carry out sub-delegation so that everyone has equal opportunity, said Appiah.

Sub-delegation in DEA allows small-time brokers and intermediaries to access EU markets. Brokers who do not have the capacity to become direct members of all the EU trading venues can provide their clients access to these pools of liquidity. Albeit, without having to bear the costs or maneuver the complexities of attaining memberships at all EU trading venues. These DEA sub-delegation providers may have to adhere to some very stringent rules and operational requirements to ensure compliance to market standards by their clients.

The World Federation of Exchanges has also responded to the ESMA review report. The WFE said that including users in the scope of DEA regulations is not needed. They said that DEA regulations for providers are already in place, be it under the MiFID or some other similar regime in a third country. So they see no need to duplicate the regulations.

The WFE also said that proportionality is the biggest benefit of this consultation. The streamlining of the provisions related to DEA is likely to create a more consistent approach throughout all the EU member states. This will further support business between EU members and third countries, promoting a better model for business across borders.

Industry response to the ESMA review

Several industry experts have analyzed the ESMA review report and presented their opinions on what it could mean for algo trading in the future. A white paper summarising the likely outcomes of the review and its impact on market abuses, systems, and controls has been published by a leading trading surveillance company. One possible impact is an increased focus on bonds. Until 2019, there was a negligible volume of algo trading in bonds. But by the third quarter of 2019, algo trading in bonds rose up to 80%

According to analysts, this sudden growth is because of how bilateral over-the-counter trading has undergone electronification, with negligible high-frequency trading activity in this case. Seeing this trend, the ESMA review has proposed to selectively extend algo trading requirements to systematic internalizers or SIs. This brings several bond trading activities under the algorithmic trading regulations. It is seen that the focus, in this case, will primarily be on the governance of algo trading in bonds and the systemic control of algo platforms. It is also likely that notification by SIs to their national regulators, regarding the use of algo trading techniques, may be made mandatory in the near future.

However, most firms already use algorithmic trading techniques in compliance with MiFID II regulations. So applying the same regulations to other SI units will not be difficult for such firms. But for sell-side firms that operate as systematic internalizers, this proposal may not go down well. Also, experts added that there are many opt-in SIs that do not use algorithmic trading techniques. So simply extending the algo trading regulations to all SIs may not be useful or relevant.

A careful evaluation of the report also shows that market abuse in various areas has been highlighted in the ESMA review, and the need for stringent procedures and timely reporting is mentioned. This could mean that these areas will be audited more strictly by national regulators once new regulations come into effect. So systems must ensure compliance with all requirements in these areas.

The ESMA report will be submitted to the European Commission, which may then propose amendments to the existing MiFID II regime. On the other hand, the UK government is carrying out its own review of wholesale market regulations. The outcomes of this review are likely to diverge from the EU regulations. The UK report is set to be published in 2022.