New trends are shaping and re-shaping financial markets—but regulations are quick to catch up.
Consider, for example, the trend toward using algorithms (“algos” for short) to help make trading decisions. Post market crash, European regulators were wary. They understood algos had the potential to adversely affect financial markets—particularly around transient liquidity that can result when order canceling volume is high, as well as impacting markets’ infrastructure when high volumes of cancellations occur.
Algos are well within the scope of Markets in Financial Instruments Directive (MiFID) II. Regulations stopped short of banning algorithmic activity altogether, but they do clearly require firms to implement critical controls and disclosers—to avoid adversely affecting the functioning of financial markets’.
From a MiFID II standpoint, algos are considered to be systems, and the decision to transact at a particular price or quantity should be made without human intervention.
Much of the thrust of MiFID II, as noted in our recent paper, From Impact to Implementation: Addressing the Key Technology Impacts from Markets in Financial Instruments Directive II, is around technology fixes and solutions to help financial firms comply with MiFID II requirements. As you might expect, there are technology implications around MiFID II requirements and algo trading—both things to look out for in existing technology and new technology solutions that can address concerns. Here’s a look at some of them:
- Before algos can be released into production, MiFID II requires that test packs, trade populations and environments be reviewed for compliance. Organizations should apply their best testing methods, but they also now need to document the testing and review process and be able to provide evidence as needed.
- Trading venues will need to provide an appropriate environment for testing algos, Per MiFID II, they’ll additionally need to identify orders generated by algos, and know what algo strategy is employed by the counterparty.
- Market making falls within the domain of algos and MiFID II too. Financial institutions engaged in certain algo activities are obliged to continually make markets, depending on certain conditions.
- Business continuity plans are required by MiFID II, and for some businesses this includes an algo specific “kill switch,” which may require sufficient human monitoring of the market and of executed transactions.
Technical solutions and processes can support financial firms as they work to comply with MiFID II requirements. Our paper offers much more on algos, as well as a deeper discussion on a variety of other business processes and strategies that fall under new scrutiny with MiFID II. I invite you to take a look.