A presentation at The 2015 Copenhagen Business School Symposium on High-Frequency Trading. Alberto Garcia, Senior officer, ESMA

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Implications of MiFID II (the regulator’s view)
Alberto Garcia, ESMA

2. Driving forces of the media discussion on algo
trading and HFT
• “The market is rigged” (Michael Lewis)
• OR
• “The changes (due to algorithmic trading) to the society at
large have been mostly positive, depositing the saved
dollars directly to investor pockets (…) Some brokers,
whose lifestyle has been significantly reduced by
technology, attempt to demonize HFT (…)” (Irene Aldridge)
14. Oktober 2015 | Location,City

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3
What is in the ESMA regulatory package?
Regulatory technical standards on:
- Organisational requirements for investment firms
- Organisational requirements for trading venues
- Tick sizes
- Market making
- Order-to-trade ratio
- Co-location and fee structures
- Identification of the most relevant market in terms of liquidity for the
notification of trading halts
Technical Advice to COM on:
- Identification of HFT
- Specification of Direct Electronic Access

4. IDENTIFICATION OF HFT
Why is the identification of HFT relevant?
– Obligation to become an investment firm
– Specific record keeping obligations
ESMA made three proposals to the COM for identifying HFT:
• Absolute threshold per instrument: the average number of messages sent per
trading day to any single liquid instrument traded on a venue is above 2
messages per second.
• Absolute threshold per trading venue and per instrument: on average at least 4
messages per second with respect to all instruments across a venue or 2
messages per second traded with respect to any single instrument traded on a
venue.
• Relative threshold: median daily lifetime of its modified or cancelled orders falls
under a threshold below the median daily lifetime of all the modified or cancelled
orders submitted to a given trading venue.
14. Oktober 2015 | Location,City

5. Organizational requirements for investment firms
• Identification of responsibilities with respect of all aspects of algorithmic
trading: senior management, compliance and risk management
functions.
• Testing: it is the investment firm’s responsibility to its algorithms,
systems and strategies adequately tested:
 Should all algorithms be tested? No pure “investment decision
algos” deployed manually.
 Two types of testing to be undertaken
o conformance testing; and
o “testing against disorderly trading conditions”.
 Separation testing environment/production environment (Knight
Capital)
• Annual self-assessment and stress test of the systems
14. Oktober 2015 | Location,City

6. Organizational requirements for investment firms
• Kill switch
• Different types of risks should be addressed by different types of controls:
- Pre-trade controls (price collars, maximum order value, maximum order
volume and maximum messages limit). Also repeated automated execution
throttles.
- Real-time monitoring of trading activity = real-time alerts (less than 5
seconds). NOT real-time reaction to those alerts). Trader in charge +
independent risk control function.
- Post-trade risk-management controls (post-trade reconciliation).
- Potential market abuse or breach with rules of trading venues through
specific surveillance systems.
• Business continuity arrangements (scenarios should represent at least at least
unavailability of systems, staff, work space, external suppliers or dependencies
and critical data and documents through loss or alteration).
14. Oktober 2015 | Location,City

7. DIRECT ELECTRONIC ACCESS
- DEA providers shall always retain responsibility for the
trading that their DEA clients carry out in their name.
- Due diligence on potential DEA clients and periodical review
once they are clients.
- DEA providers shall always apply their own pre-trade
controls to the DEA order flow.
- Identification of the different clients sending orders using
DEA so that the DEA provider can block or cancel their
orders if necessary. In particular in the case of sub-
delegation.
14. Oktober 2015 | Location,City

8. Organisational requirements for trading venues
• Identification of responsibilities with respect of all aspects of algorithmic trading:
senior management/board and compliance.
• Extensive rules on outsourcing of operational functions (to avoid “empty shells”),
including the approval of the national competent authority in some cases.
• Due diligence for admitting new members performing algorithmic trading
according to pre-defined standards (pre-trade controls, key staff, conformance
testing…).
• Testing obligations:
o For the trading venue’s own systems
o For the members of the trading venue:
 Conformance testing, for which the trading venue has to provide an
environment that their members/potential members have to use
 Testing against disorderly trading conditions
14. Oktober 2015 | Location,City

9. Organisational requirements for trading venues
• Testing against disorderly trading conditions:
 Trading venues have the obligation to provide an
environment to perform such testing, that can be:
o Simulation facilities; or
o Testing symbols
 However, members are NOT obliged to use those means.
They can test their algos using external IT providers
 Members have to certify to the trading venue that they have
performed this type of testing and the means used for that.
Trading venues do NOT have to validate that testing.
14. Oktober 2015 | Location,City

10. Organisational requirements for trading venues
• Resilience of trading venues: at least twice their historical peak of messages expressed
as the highest number of messages per second recorded on that system during the
previous five years.
• Annual self-assessment and stress test of the systems
• Business continuity arrangements (unavailability of systems, staff, work space, external
suppliers/dependencies and critical data and documents through loss or alteration),
including a back-up site.
• Controls:
- Pre-trade controls. price collars; maximum order value; maximum order volume.
- Mechanisms to manage volatility (trading halts/order price collars)
• Direct Electronic Access:
- Trading venues shall specify the minimum requirements for the due diligence process to
provide DEA
- Sponsored access clients have to be expressly authorised by the trading venue.
14. Oktober 2015 | Location,City

11. Tick sizes
• What does it aim at?
Two main purposes:
- Find an adequate trade-off between the possibility of price
improvement and excessive flickering in the order book. To
that end, ESMA has used are two “optimal” spread-to-tick
ratios:
o [1.5-3] for liquid shares and depositary receipts; and
o [1.5-5] for illiquid shares and depositary receipts.
- Prevent using tick sizes as a competition tool that may lead
to a “race to the bottom”.
14. Oktober 2015 | Location,City

12. Tick sizes
• Are all the MiFID instruments covered by the new regime? No. Only
shares, depositary receipts and ETFs that have as underlying shares
and depositary receipts.
• How it operates?
EU trading venues should apply the six “tick size” tables for shares and for
depositary receipts to be applied based on the liquidity of an instrument,
measured in terms of average number of trades (ANT) in the most liquid
market in Europe  the higher the ANT, the smaller the tick sizes
applicable to the incoming orders.
ETFs would only use the tick sizes of the highest liquidity band.
14. Oktober 2015 | Location,City

13. Market making strategies, agreements and schemes
• How many types of market making are out there?
Hard to know: Article 4(1)(7) MiFID II, Article 17 (4) MiFID II and Article 2 of
Short Selling Regulation overlap.
• Which is the approach followed by ESMA in the RTS?
Market making obligations for algorithmic traders are construed
independently from any other piece of legislation.
Market making obligations should foster the presence of liquidity providers
in stressed market conditions, not in normal market conditions, where each
trading venue may decide what fits best to its own business model.
14. Oktober 2015 | Location,City

14. Market making strategies, agreements and schemes
FOR THE MEMBERS OR PARTICIPANTS OF A TRADING VENUE
• Obligation to sign a market making agreement with the trading venue/s
when posting firm, simultaneous two-way quotes of comparable size
and competitive prices when dealing on their own account in at least
one financial instrument on one trading venue for at least 50% of the
daily trading hours of continuous trading at the respective trading venue,
excluding opening and closing auctions, for half of the trading days over
a one month period.
• Obligations once the market making agreement has been signed:
Posting firm, simultaneous two-way quotes of comparable size and
competitive prices in no less than one financial instrument on the trading
venue for no less than 50% of the hours during which continuous trading
takes place during daily trading hours excluding opening and closing
auctions, and calculated for each trading day.
14. Oktober 2015 | Location,City

15. Market making strategies, agreements and schemes
FOR TRADING VENUES:
• Monitoring the performance of the MM obligations under the
agreements.
• Having in place a market making scheme  continuous
trading of liquid shares, ETFs, options and futures on them
and liquid equity index futures and options.
Are the terms “market making agreement” and “market making
scheme” equivalent? NO
But, do trading venues have to pay in all cases under the MM
scheme? NO  stressed market conditions
14. Oktober 2015 | Location,City