Lecture 6 Key Market (Micro)Structure Rules PDF

Lecture 6 Key market (micro)structure rules Diego Valiante, Ph.D. Opinions expressed are strictly personal and cannot be LEIF Master Programme attributed in any way to the Eu...

Lecture 6 Key market (micro)structure rules Diego Valiante, Ph.D. Opinions expressed are strictly personal and cannot be LEIF Master Programme attributed in any way to the European Commission.  Agenda Key developments in market structure (secondary markets) Trading venue classification – Auction vs Dealer markets – Trading system – Multilateral vs bilateral matching/execution – MiFID trading venues Trade reporting Market microstructure rules – Algorithmic trading – High-Frequency Trading (HFT) and – Direct Electronic Access (DEA) © Valiante Diego  Trading value chain © Valiante Diego  The removal of ‘concentration rules’ for secondary markets The gradual removal of ‘concentration rules’ for exchanges across the world has opened up the trading infrastructure services and multiplied the number of trading platforms. markets have fragmented... FIGURE 1 NYSE % of consolidated volume in NYSE-listed 100.0% 79.1% 80.0% 60.0% 40.0% S 25.1% 20.0% 0.0% 2005 2009 source: Securities and Exchange Commission (2010) FIGURE 3 NYSE-listed consolidated 24 average daily volume (billions of shares) 8 2 © Valiante Diego 6 5.9 2 1  Benefits and costs of opening up Benefits: – New trading venues entering especially in the ‘blue chips’ segment – Explicit execution costs dropped (e.g. bid-ask spreads) – Implicit execution costs’ reduction claimed by some is disputed due to market fragmentation – Consolidation among stock exchanges was attempted Risks: – Higher risk of ‘cream skimming’ (selecting the order flow with practices, such as payment for order flows) effects on uninformed trades (liquidity fragmentation, which implies higher market impact) – More complex supervision © Valiante Diego  Market structure developments Competition has also led to innovation and a quick rise of algorithmic and high-frequency trading tools, mainly applied to market-making More Quotes per Stock Faster Executions and order execution services. Average Quotes per Minute Market Order Execution Speed (ms) 600 30 500 25 20 400 NASDAQ-listed 15 300 NYSE-listed Russell 2000 10 200 S&P500 5 100 0 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2003 2004 2005 2006 2007 2008 2009 NYSE-listed Nasdaq-listed 13 Cancellation/ 14 Execution Ratio 40 35 30 25 20 15 10 5 0 2002 2003 2004 2005 2006 2007 2008 2009 15 © Valiante Diego  Market structure The business model of exchanges has changed too… © Valiante Diego  Main trend in regulatory approach to the new market structure (via MiFID/R) 1. Investment Service Directive 93/22/EEC à focus on minimum standards and passporting. 2. MiFID Directive 2004/39/EC à focus on opening up markets (removal of concentration rule) and enlarging the investor protection framework. 3. MiFID Directive 2014/65/EU & Regulation n. 600/2014 à focus on the post-crisis reform effort to increase transparency & restore confidence and stability in the integrity of the financial system. © Valiante Diego  Trading venue classification © Valiante Diego  Market structure Auction (order-driven or quote driven in continuous or discrete time periods) vs bilateral (e.g. request for quote) markets Auction Markets Dealer Markets PROs PROs - High transparency - Handling of illiquid products and block - Price informational efficiency sizes - Order flow competition - Resiliency (to information - Low transaction costs (especially for asymmetries) small trades) - Execution certainty CONs CONs - Market impact - Costs - Market breakdown (information - Opacity (price formation) asymmetries) - Accessibility (if OTC) - Operational risks (capacity) - Low competitive pressures © Valiante Diego  Trading venue classification The trading venue classification is at core of EU legislation on market structure. The objectives of this classification are: 1. Minimise cream skimming Ensuring that market fragmentation doesn’t become liquidity fragmentation – Rec 10 (MiFIR) à all organized trading should be conducted on regulated venues and is fully transparent (internalization is an exception) 2. Protect market quality and integrity Promoting an efficient trading environment whereby participants are treated fairly and non-discriminatorily © Valiante Diego  A ‘trading system’ Three components: 1. Matching system a. Order-driven (multilateral) b. Quote-driven (multilateral) c. Request For Quote (bilateral) 2. Organisation of trading sessions a. Continuous auctions b. Batch Auctions 3. Information systems For instance, pre/post trade data disclosure. A trading system relies on matching and execution services. The configuration changes whether it is an auction or a dealer market. These trading systems are NOT bulletin boards. – Bulletin boards only advertise interests, while trading systems imply binding quotes (actionable) or (actionable or non-actionable) Indications of Interests (IoIs) © Valiante Diego  Multilateral matching service Multilateral matching service (trading venue) – Multilateral markets are those settings whereby a market operator or an investment firm operate as riskless counterpart that brings together on a systematic basis all sorts of buying and selling interests, i.e. the operator/firm does not apply discretion on how orders are matched (so after receiving the order; ex post), as well as about access to the platform (supply of buying and selling interests) and the supply of products that can be admitted to trading. ‘Multilateral’ does not simply mean bringing together ‘multiple’ buying and selling interests. A ‘multilateral matching system’: 1. Doesn’t apply discretion in the 1. Matching system; 2. Admission of products to trading; and 3. Access to the platform. 2. Relies on rules and objective criteria available ex ante 3. There is no fiduciary mandate vs clients 4. Doesn’t match orders against proprietary capital or trade on own account © Valiante Diego  Bilateral matching service A ‘bilateral matching system’: 1. Applies discretion to either matching, admission products to trading or access to the platform 2. It may trade against proprietary capital 3. It may give rise to a mandate between the client and the intermediary (fiduciary duty, which may lead to a best execution obligation) 4. It is de facto a non-neutral counterpart Regulation is technology neutral, so the assessment only looks at whether the matching service is equivalent to bilateral or multilateral matching. © Valiante Diego  Multilateral vs bilateral (discretionary) matching Matching Execution on behalf Dealer A Dealer A Indication of interest $100 mn Interdealer platform Inter-dealer broker (voice or electronic) $50 mn $25 mn Dealer F Dealer B Dealer F Dealer E Dealer E $25 mn Dealer C Dealer D Dealer H Dealer C Dealer G Multilateral setting Bilateral setting © Valiante Diego  Multilateral vs bilateral (discretionary) execution Execution on behalf (bilateral) Multilateral matching Party A Party A Mandate B R Fiduciary O Trading duty K venue E Looking for R counterparty Multiple Party B buying/selling interests © Valiante Diego  Interaction between bilateral/multilateral trading systems Clients Broker/Dealer (AM, etc) External liquidity pools Parent Orders Broker/Dealer Split and Front Desk Diced (algorithmic trading) Internal Open Markets Crossing System Child Orders External Lit Markets Dark Markets Crossing Systems Source: Valiante (2011), MiFID 2 Task Force Report BCN © Valiante Diego  Multilateral vs bilateral matching systems Liquidity indicators and the spectrum of matching/execution mechanisms © Valiante Diego  Mapping trading venue types OTFs Source: Valiante (2012) © Valiante Diego  MiFID Trading Venues © Valiante Diego  MiFID Trading Venues for equities Trading Venues Neutral Non-Neutral Multilateral matching Bilateral matching Non-discretionary access Discretionary access & execution Non-discretionary execution Best execution Riskless counterpart RMs MTFs SIs © Valiante Diego  Neutral trading venues – Regulated Markets & MTFs Regulated markets remain the venues of admission to trading and official listing for most companies – They are authorised at national level – They are not a MiFID investment firm, subject to passport, but they are partially regulated by MiFID – Admission to trading always accompanied by a prospectus (under Prospectus Regulation) and other specific requirements (under EU Directive 2001/34) Admission of securities to trading/official listing on an MTF may not always result in the obligation to issue a prospectus (unless the communication qualifies as ‘offer of securities to the public ex art. 2.1(d) Prospectus Reg. 2017/1129) MTFs are trading venues that can operate under pre-trade transparency waivers (as per MiFIR rules) © Valiante Diego  Neutral trading venues – Multilateral Trading Facilities (MTFs) SMEs Growth Market (lighter regime for authorisation, including prospectus, as well as lighter market abuse regime) – SME defined as listed companies with less than €200 million market cap – At least 50% of listed companies must be SMEs © Valiante Diego  Neutral trading venues – Other requirements Other requirements (incl. risk management, order handling, conflicts of interest) for secondary markets are aligned between RMs (Title III, MiFID II) and MTFs (art. 18-20, MiFID II) – To avoid undue operational risk, and to allow risk identification and monitoring. – Contingency arrangements in case of disruption – Identification of conflicts of interest in their operations ‘Effective’ procedures for risk assessment – Monitoring and evaluation of the adequacy and effectiveness of the systems, internal control, standards and arrangements Outsourcing is possible – ‘Non-core’ operational services – ‘Core’ à If no harm to quality of internal controls (art. 16.5, MiFID II) © Valiante Diego  SI’s key characteristics Def: “An investment firm which, on an organized, frequent systematic and substantial basis, deals on own account when executing client orders outside a RM, MTF or OTF without operating a multilateral system” (art. 4.1(20) MiFID II) Two cumulative conditions: – ‘frequent and systematic’ à number of OTC trades among client orders – ‘substantial’ à size of OTC trading vs the IF or the total trading EEA Executing client orders against own capital (in any case) – Unless under the OTC exemption No third-party orders involved! – Old broker-dealer crossing networks are outlawed by the trading obligation in MiFIR “[…] an exclusion from that trading obligation should be provided if there is a legitimate reason. Those legitimate reasons are where trades are non-systematic, ad-hoc, irregular and infrequent, or are technical trades such as give-up trades which do not contribute to the price discovery process. Such an exclusion from that trading obligation should not be used to circumvent the restrictions introduced on the use of the reference price waiver and the negotiated price waiver or to operate a broker crossing network or other crossing system. (Rec. 11, MiFIR) Registration by asset class for both equities and non-equities (the operator should do it and not the regulator) Two-way (firm) quotes – No pre-trade if below standard market size or illiquid Liquidity calibrated by instrument type (equity, bonds, derivatives) Best execution and other CoB rules apply © Valiante Diego  Systematic internalisers (SIs) A success with MiFID 2 and MiFIR ? – Only 13 with MiFID I, now more than 100 and counting! – No shift to public markets and successful in capturing most of OTC trades © Valiante Diego  MiFID Trading Venues for non-equities Trading Venues Neutral Non-Neutral Multilateral matching Bilateral matching Bilateral maching Non-discretionary access Non-discretionary access Discretionary access & Non-discretionary execution Discretionary execution execution Riskless counterpart Best execution Best execution OTFs RMs MTFs SIs (non-equity) © Valiante Diego  Organised Trading Facilities (OTFs) Definition (art.4.1(23), MiFID II) – “‘Organised trading facility (OTF) means a multilateral system, which is not a regulated market or MTF and in which multiple third-party buying and selling interests in bonds, structured finance products, emission allowances or derivatives are able to interact in the system in a way that results in a contract in accordance with Title II of this Directive” Only for non-equity Level playing field with MTFs and RMs – But divergence on execution rules © Valiante Diego  OTFs characteristics (and differences with RMs & MTFs) 1. ‘Non-discretionary’ access à ex-ante rules – Membership – Admission of products to trading 2. BUT discretionary execution (matching) i. Deciding when to place or retract an order on the OTF, and ii. Deciding if and when to match a specific client order with another order available in the system at a given time, provided it is in compliance with specific instructions received from a client and best execution obligations. 3. No proprietary capital (only illiquid sovereigns), but ‘matched principle’ (with client’s consent) – Matched principle transaction is a transaction where the facilitator interposes itself between the buyer and the seller to the transaction in such a way that it is never exposed to market risk throughout the execution of the transaction, with both sides executed simultaneously, and where the transaction is concluded at a price where the facilitator makes no profit or loss, other than a previously disclosed commission, fee or charge for the transaction. – Primarily this is to provide access to clearing and/or maintain post-trade anonymity. 4. BUT application of fiduciary duties (best execution) 5. Same organisational requirements for RMs and MTFs (art. 18-20 MiFID II) 6. No interaction allowed with SI © Valiante Diego  Mapping trading venue types OTFs Source: Valiante (2012) © Valiante Diego  Trade reporting © Valiante Diego  Greater transparency Crucial function in financial markets – Micro Price discovery Market integrity and investor protection – Macro Monitoring systemic risk Transparency, however, is no panacea – Market Impact (in particular, pre-trade transparency) – Capital commitment (bilateral markets) Two (pre-trade and post-trade) transparency regimes in MiFID 2 - MiFIR 1. Equity and equity-like instruments (including actionable Indication Of Interests, IOIs) 2. Non-equity instruments (bonds, structured products and derivatives) © Valiante Diego  Pre-trade transparency © Valiante Diego  Pre-trade transparency in multilateral (auction) equity markets “A trading venue shall make public current bid and offer prices and the depth of trading interests at those prices which are advertised through their systems” (art. 4 MiFIR) Quotes need to be published even in absence of trade taking place (i.e. expired quotes) Pre-trade disclosure is necessary for auction mechanisms (Hendershott and Jones, 2003) – On September 23, 2002, the SEC enforced Regulation ATS by requiring that the Island electronic communications network (ECN) comply with ATS display requirements in several of the highest-volume exchange- traded funds (ETFs) where Island dominated trading and price discovery. – Island chose to comply by going “dark,” no longer displaying its automated limit order book to any market participant. Trading and price discovery continue on Island after it goes dark, but at much lower levels, and the repercussions are observable across other markets. – Trading costs (effective spreads) in all ETFs decline in non-Island markets that pick up market share, © Valiante Diego  Market impact risks Parasitic traders may seek to exploit the existence of the large buy order by “front running” the order, or by using “order matching” strategies, i.e. by posting a limit order at a price one tick more favourable than the existing order. quote matching strategies. Harris (1996) finds that traders are more likely to display their orders when the tick size is larger, as the greater tick size makes front-running more costly. – As the large order might no be triggered so easily, since the distance between limit orders is larger. – The parasitic trader has to always arrive before the large order in the order book. © Valiante Diego  Pre-trade transparency – Waivers Dark Liquidity (dark pools or hidden orders) allowed Under waivers from pre-trade disclosure in specific situations (art. 4 MiFIR), such as: – Reference price (trading at midpoint price from market most relevant in liquidity terms or first market where it was admitted to trading, if reliable) – Large-in-scale transactions (an order be large in scale compared with normal market size as defined in the MiFID II legislation and calculated by ESMA) – Negotiated trade (negotiated transactions provided that transaction takes place at or within the current volume-weighted spread, or is subject to conditions other than the current market price of the share (e.g. a volume weighted average price transaction) – Order management facility (it can be used when orders are held in an order management facility maintained by a trading venue pending those orders being disclosed to the market) Rule-based approach and ongoing supervision (review after 2y) © Valiante Diego  Pre-trade transparency – Double volume cap Where is the inflection point, i.e. the amount of dark trading that affects market liquidity? à understood as around 8-10% of EEA trading Additional limitation to pre-trade transparency for equity is the double volume cap (DVC) on volumes traded on dark venues in the previous 12 months (art. 5 MiFIR) – Applicable only to reference price and negotiated trade waivers – Volume a single venue < 4% of all transactions in all EEA venues – Global volumes in all the venues using these two waivers < 8% of all transactions in all EEA venues If DVC is breached, trading suspension within 2 days and for at least 6 months, if this happens © Valiante Diego  Pre-trade transparency For non equity (bond, structured finance and listed derivatives), instead: – Structurally more marginal role for pre-trade transparency Capital commitment Few dealers (low search costs) Dominance of counterparty risk – More derogations to pre-trade transparency are available Large in scale orders compared with normal market size (LIS) Liquidity profile (including type and number of market participant, i.e. ISIN) – Currently 611 liquid bonds under MiFID II transparency out of more than 70,000 bonds (ESMA, October 2019) Market model/trading system (e.g. quote driven, RFQ, etc) – SSTI (Size Specific To Instrument) à actionable indications of interest in request-for-quote and voice trading systems that are above a size specific to the financial instrument, which would expose liquidity providers to undue risk and takes into account whether the relevant market participants are retail or wholesale investors. Characteristics of trading activity – Orders in an order management facility of a trading venue pending disclosure as per art. 4 RTS 2 (including iceberg orders). © Valiante Diego  Overview of pre-trade transparency waivers © Valiante Diego  Pre-trade transparency (for info) Notification process for waivers In case of disagreement among authorities, ESMA can intervene to mediate (but its final opinion is not binding) © Valiante Diego  Post-trade transparency © Valiante Diego  Post-trade transparency !!! Different from transaction reporting, which is confidential information to NCAs for supervisory purposes !!! For equity instruments – “Market operators and investment firms operating a trading venue shall make public the price, volume and time of the transactions executed” (art. 6, MiFIR) – Shares, actionable IoIs, Equity-like (depository receipts, ETFs, and share certificates) – Admitted to trading on RMs, MTFs, OTFs and SI in specific cases For non-equity instruments – “Market operators and investment firms operating a trading venue shall make public current bid and offer prices and the depth of trading interests at those prices which are advertised through their systems.” art.8, MiFIR) – Bonds, structured finance, derivatives instruments, etc. Time limits for trade reporting – To be delivered as close to real-time as possible “Close to real time as technically possible” (art. 64.1 MiFID II) –...within 1 minute, actually... – …but no similar obligation on IFs for post-trade reporting (art. 20-21 MiFIR)! A flag for whom (what kind of entity or automated system) is executing the transactions has been introduced (e.g. algo trading) © Valiante Diego  Post-trade transparency (for info) Non-equity transparency calibration – To be done ‘Instrument by instrument’ (e.g., IRS, CDSs) Liquidity measures (e.g., frequency of trades) Suspension of the obligation if below the liquidity threshold Other requirements – Avoiding double-reporting with trade repositories (TRs) TRs will transmit reports – Aggregate net exposures by leveraging on existing facilities (TRs under EMIR) Deferred publication for non-equity if > standard dimension and specific volume (no later than the end of the day) – Raised highbrows among active dealers in OTC markets © Valiante Diego  Post-trade transparency (to recap) Three sets of trading data 1. Confidential data [transaction reporting]) 2. Trade reporting (pre and post-trade) 3. Reference data (to identify the financial instrument; e.g. ISIN) Data publication formats for markets and NCAs are different according to the type of trading data. © Valiante Diego  Market data provision and consolidated tape © Valiante Diego  Approved Publication Arrangements (APAs) © Valiante Diego  Approved Publication Arrangements (APAs) Def.: “Person authorised [..] to provide the service of publishing trade reports on behalf of investment firms under artt. 20-21, MiFIR” (Art. 4.1(52) MiFID II) – Improve the quality of trade reporting (especially for OTC equity trades) – Contribute to make the data easy to consolidate with data from trading venues Post-trade information of a transaction concluded on a trading venue must be sent by the IF to APAs (artt. 20-21, MiFIR) – IFs can report to more than one APA An APA can be an operator of a trading venue, which report other data (under art. 6 and 10 MiFIR) © Valiante Diego  Approved Publication Arrangements (APAs) (for info) Organisational requirements – Conflicts of interest and non-discriminatory treatment of information with separation of business functions (art. 64.3, MiFID II) – Security mechanisms and back-up facilities (art. 64.4, MiFID II) – System to check completeness of reports (art. 64.5 MiFID II) “Close to real time as technically possible” (art. 64.1 MiFID II) –...within 1 minute, actually... – …but no similar obligation on investment firms for post-trade reporting (art. 20-21 MiFIR)! © Valiante Diego  Approved Publication Arrangements (APAs) (for info) Technical requirements – Format to facilitate consolidation (facilitate product homogenisation) Incentive issue for incumbents – Granularity and accuracy for time stamping – Adding identifier to the instrument (among 27 flags!) Conduct requirements – Non-discriminatory access to collected information – Disaggregated data (art. 12 MiFIR) Pre and post-trade, asset class, currency and so on. But bundles are possible – Reasonable Commercial Basis (RCB; art. 13 MiFIR) Raw market data High prices and unfair commercial practices © Valiante Diego  Consolidated Tape Providers (CTPs) (for info) © Valiante Diego  Consolidated Tape Providers (CTPs) (for info) Def.: “a person authorised [..] to provide the service of collecting trade reports for financial instruments [..] from TVs and APAs and consolidating them into a continuous electronic live data stream providing [post-trade] price and volume data per financial instrument” (art. 4.1(54)) Also for non-equity financial instruments (‘gain experience’, though; Rec. 118, MiFID II) Same information disclosure than APAs, plus data to recognise algo executing transaction within the firm and flag for transaction under waivers Organisational requirements like APAs – Conflicts of interest arrangements (business functions separation) – Security mechanisms and back-up facilities (incl. adequate resources) © Valiante Diego  Consolidated Tape Providers (CTPs) (for info) Information is free of charge after 15 minutes “Reasonable commercial basis” applies (art. 65.1 MiFID II) – Unbundling, non-discrimination, per-user pricing. Fast access to info in formats that are easily accessible and utilisable by participants (cross-referencing) Obliged to collect information from all APAs, including new (with a 6 months grace period) Make sure that there is no duplication (flags applied by APAs). A public utility service? © Valiante Diego  To sum up There are three main data communication service providers – Approved Reporting Mechanism (ARM) for transaction reporting – Approved Public Arrangements(APA) for trade reporting – Consolidated Tape Provider (CTP) for post-trade reporting consolidation © Valiante Diego  Concluding remarks Market data provision is a complex area to regulate due to multiple factors (e.g. exchanges’ market power, digital distribution, supply-driven factors like latency, etc.) Without additional standardisation of MiFID trade reports (i.e. identifiers), the accessibility and availability of centralised data solutions will be still limited. The consolidated tape, as designed [post-trade], does not create sufficient commercial incentives to be provided by the market. © Valiante Diego  Open access (for info) © Valiante Diego  (Reverse) Open access infrastructure (art. 35-37, MiFIR) (for info) 1. Open access to a trading venue – Reasons for denial Operational risks (e.g. IT system compatibility with CCPs or other trading venues) Significant undue risks (e.g. threat to the viability of the venue) – Access conditions Standardised contractual terms Non-discriminatory pricing – Subject to two general condition 1. No need for Exchange-traded derivative ‘interoperability’ 2. No ‘liquidity fragmentation’ (market functioning) © Valiante Diego  (Reverse) Open access infrastructure (art. 35-37, MiFIR) (for info) 2. Open access to benchmark instruments (including Indexes, art. 37, MiFIR) – ‘Benchmark’ means any index by reference to which the amount payable under a financial instrument or a financial contract, or the value of a financial instrument, is determined, or an index that is used to measure the performance of an investment fund with the purpose of tracking the return of such index or of defining the asset allocation of a portfolio or of computing the performance fees (art. 3.1(3) Reg. 2012/1011/EU, Benchmark Regulation) – Access to data feed and licenses to trading venues and clearinghouses in a way that allows negotiation Reasonable commercial price, non-discriminatory, reasonable and fair – Enough information to understand composition, methodology and pricing 3. Open access to a clearing infrastructure (art. 35, MiFIR; see next lecture) © Valiante Diego  Algorithmic trading, HFT and DEA © Valiante Diego  https://www.cnbc.com/video/3000377283 © Valiante Diego  Definitions Definition of algorithmic trading (art. 4(1)(39), MiFID II) – ‘Automatic’ determination of individual orders parameters (e.g. whether to initiate the order, timing, price, etc) with limited or no human intervention Algo trading does not include routing and confirmation systems (if there are no pre-determined trading parameters; art. 18 RTS Reg. 2017/565) HFT is a subset of algo trading (often used by arbitrageurs and by professional investors in order to improve their trading strategies) with three key characteristics (art. 4(1)(40), MiFID II): 1. Infrastructure to minimise latency (incl. co-location and direct market access) 2. High messaging (orders, quotes, cancellations; at least 2 messages per second in a single fin. Instrument or 4 for all fin. Instruments on a trading venue; art. 19 RTS Reg. 2017/565) 3. System-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders ESMA advised to consider the use of proprietary capital too (as it is hard to rely only messaging, which can come from brokerage services too) © Valiante Diego  Definitions Main trading strategies that can be pursued through HFT systems (Fleuriot, 2010): – Market-making (orders sent to capture the spread), – Arbitrage (instantaneous or statistical) and – Speculation (event-driven strategies to predict future price movements) Article 2(1)(d)(iii) of MiFID II states that any person that applies a high frequency algorithmic trading technique is required to be authorised as an investment firm. © Valiante Diego Source: ESMA MiFID II Review Report 2021. © Valiante Diego  General views - Benefits “Despite commonly held negative perceptions, the available evidence indicates that high frequency trading (HFT) and algorithmic trading (AT) may have several beneficial effects on markets. However, HFT/AT may cause instabilities in financial markets in specific circumstances.” (UK Gov Office for Science 2012). Benefits – Market prices have become more efficient, consistent with the hypothesis that computer-based trading links markets and thereby facilitates price discovery and gains in spreads without increasing volatility (Hendershott, Jones & Menkveld, 2008; Brogaard, 2010). – Liquidity, as measured by bid-ask spreads and other metrics, has improved – Transaction costs have fallen for both retail and institutional traders, mostly due to changes in trading – Market structure, which are related closely to the development of HFT in particular © Valiante Diego  General views - Risks Risks – Claims of market manipulation using HFT techniques are reported by institutional investors such as pension funds and mutual funds in different countries. High perceived levels of abuse may harm market liquidity and efficiency for all classes of traders. – Rising complexity of supervision (if also combined with an already complex market design) – More frequent technical glitches – HFT arms race failures (sniping and overinvestment; see next slides) © Valiante Diego  HFT’s arms race and market design failure (Budish et al. 2014; case study) © Valiante Diego  HFT’s arms race and market design failure (Budish et al. 2014; case study) Market Failure 1: Sniping (tax on liquidity providers) – Mechanical arbitrage opportunities are built into Central Limit Order Book (CLOB) market design (continuous trading) in its choppy trading at microsecond level (giving space for structural arbitrage). – These ‘built-in’ arbitrage opportunities violate weak-form EMH (Fama, 1970) – Market looks highly efficient in time space, but it isn’t efficient in volume space Lots of volume that gets transacted at the instant prices become stale – HFTs earn rents from symmetrically observed public information (available to all at the same time) Even for public / technical info, somebody is always first to react Market Failure 2: Arms Race – The arbitrage rents then induce an arms race for speed (so competition on speed and not on price) – Mathematically, a prisoners' dilemma that leads to overinvestment – In the UK, 22% of trading volumes is estimated to be HFT races Solution? – Move from continuous serial auctions to discrete batch auctions (250 ms) For more details on quantification https://www.fca.org.uk/publication/occasional-papers/occasional-paper- 50.pdf © Valiante Diego  Algo surveillance © Valiante Diego  Ex ante surveillance on algorithmic trading (art. 17, 48, MiFID II) At least yearly description of algo strategies to regulators (no approval requested) – Testing of algos by IFs in (live and non-live) trading environments (also offered by trading venues) ‘Continuous operation’ obligation for algo trading pursuing market-making strategies (art. 17.3, MiFID II) – (a) carry out this market making continuously during a specified proportion of the trading venue’s trading hours, except under exceptional circumstances, with the result of providing liquidity on a regular and predictable basis to the trading venue; – (b) enter into a binding written agreement with the trading venue which shall at least specify the obligations of the investment firm in accordance with point (a); and – (c)have in place effective systems and controls to ensure that it fulfils its obligations under the agreement referred to in point (b) at all times. Orders-to-transaction ratio and minimum tick size (art. 48-49, MiFID II) – Tick size linked to bands of liquidity © Valiante Diego  Ex post surveillance & emergency procedures Circuit breakers (art. 48.5, MiFID II) – “Member States shall require a regulated market to be able to temporarily halt or constrain trading if there is a significant price movement in a financial instrument on that market or a related market during a short period and, in exceptional cases, to be able to cancel, vary or correct any transaction.” – Specific conditions for halting trade to be disclosed to NCAs and to ESMA Rejecting ‘erroneous trades’ Additional conditions for the halt in delegated acts (RTS 7), including ‘volatility bands’ Limits on cancellation ratios – “…systems to limit the ratio of unexecuted orders to transactions that may be entered into the system by a member or participant, to be able to slow down the flow of orders if there is a risk of its system capacity being reached and to limit and enforce the minimum tick size that may be executed on the market.” (art. 48.6, MiFID II) © Valiante Diego  Circuit breakers in action The number of events triggering circuit breakers in the second and third week of March reached record levels of around 2,400 and 4,000 respectively (ESMA 2021) © Valiante Diego  Direct electronic access (DEA) "Direct electronic access" in relation to a trading venue, means “an arrangement where a member or participant or client of a trading venue permits a person to use its trading code, so the person can electronically transmit orders relating to a financial instrument directly to the trading venue.” (art. 4.1(41), MiFID II) Direct Market Access (DMA) vs Sponsored Access (SA) (art. 4.1(41), MiFID II) – “arrangements which involve the use by a person of the infrastructure of the member or participant or client, or any connecting system provided by the member or participant or client, to transmit the orders (direct market access) and arrangements where such an infrastructure is not used by a person (sponsored access)” © Valiante Diego  Direct electronic access (DEA) Secondary securities markets Investors’ offers Membership /Access Fee Intermediaries DMA/SA Trading Trading Platform B Platform E Trading Trading Platform H Platform A Execution Fee Trading Trading Platform C Platform G Trading Trading Trading Platform D Platform F Platform I DMA/SA Membership Intermediaries /Access Fee Investors’ bids Source: Authors’ own elaboration. © Valiante Diego  Direct electronic access (DEA) Benefits – Direct participation to order books (all trading auctions) and contribution to liquidity – Reducing latency and trade errors – Lower spread Costs – Higher direct commissions – Direct impact on liquidity of trading errors © Valiante Diego  Direct electronic access (DEA) Role of investment firms that provide DEA – Written agreement between IF and users with ultimate responsibility on access provider (art. 17.5, 48.7, MiFID II) Notification to NCAs when IF provides DEA – Appropriate pre set trading and credit thresholds for users (art.17.5, MiFID II) Including ‘Suitability test’ for users (plus periodic due diligence of clients) or ‘price collars’ © Valiante Diego  Key DEA/algo/HFT trading requirements for trading venues (for info) ‘Transparent, fair and non-discriminatory’ co-location rules and fees for RMs (art. 48.8-9, MiFID II) – Including suitability of users, while members or participants retain responsibility. Governance rules and clear distinction of responsibilities Appropriate staffing Predefined standards for the use of the electronic system of order execution by members Keep records for members’ due diligence (5 years) Testing messaging capacity of the venue Periodic and real-time controls Synchronisation of business clocks among venues Order to execution ratios © Valiante Diego  Recommended readings Valiante, D., & Lannoo, K. (2011). MiFID 2.0: Casting New Light on Europe's Capital Markets. Brussels: Centre for European Policy Studies. (Chapters 4 and 5) available at https://www.ceps.eu/publications/mifid-20-casting-new-light- europe%E2%80%99s-capital-markets Eric Budish, Peter Cramton, John Shim, The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response , The Quarterly Journal of Economics, Volume 130, Issue 4, November 2015, Pages 1547– 1621, https://doi.org/10.1093/qje/qjv027 (skip the modelling) Armour J., D. Awrey, P. Davies, L. Enriques, J. N. Gordon, C. Mayer and J. Payne, Principles of Financial Regulation, OUP, 2016 (Chapter 7) Additional readings – ESMA, MiFID II Review Report, September 2021 https://www.esma.europa.eu/sites/default/files/library/esma70-156- 4572_mifid_ii_final_report_on_algorithmic_trading.pdf – FCA Occasional Paper No. 50: Quantifying the High-Frequency Trading 'Arms Race': A new methodology and estimates https://www.fca.org.uk/publications/occasional- papers/occasional-paper-no-50-quantifying-high-frequency-trading-arms-race-new- methodology – Valiante, D. (2013), "Setting an institutional and regulatory framework for trading platforms: Is there a case for a new trading venue under MiFID?", Journal of Financial Regulation and Compliance, Vol. 21 No. 1, pp. 69- 83. https://doi.org/10.1108/13581981311297830 – UK Government Office for Science, Computer trading: crashes and high frequency trading, https://www.gov.uk/government/publications/computer-trading-crashes-and- high-frequency-trading © Valiante Diego  Diego Valiante LEIF Master Programme [email protected] www.unibo.it