RegulationMay 20 2015

Goodbye to flash crashes

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
Goodbye to flash crashes

There has been significant press coverage recently on the reaction of the City to alleged abusive practices on Liffe in light of the ‘flash crash’ trader case.

It is important to bear in mind that these types of practice are likely to be rarer in the near future, as European legislation in the form of MiFid II, which takes effect from January 2017, will aim to make market abuse much more difficult, reducing the risks posed by algorithmic trading and its subset, the controversial high-frequency trading.

The 2010 flash crash showed that algorithmic trading can give rise to significant risks, principally systemic to the market; there is an increased risk of overloading trading venues’ systems due to large volumes of duplicative or erroneous orders leading to disorderly markets.

Moreover, HFT – in which market data is analysed at high-speed resulting in the sending and updating of large numbers of orders within a very short time period – can, as we have seen, be vulnerable to manipulative behaviour and practices amounting to market abuse such as layering and spoofing. This can happen, for example, where multiple orders are submitted at different prices on one side of the order book slightly away from the touch price, with an order then submitted to the other side of the order book (reflecting the trader’s true intention to trade) and – following the execution of that order – rapidly removing the multiple initial orders from the book.

With the introduction of the second instalment of MiFid II in 2017, algorithmic trading will be subject to a high-level regulatory scrutiny, not least because MiFid II will require high-frequency algorithmic trading firms to be authorised and supervised (currently they rely on an exemption from regulatory authorisation).

In addition, a number of regulatory requirements will be placed on such firms, including the need to put in place effective systems and controls to ensure that their trading systems are resilient and that they have sufficient capacity to deal with sudden surges in trading.

Specifically relevant to market abuse, HFT firms will have to keep accurate and timed records of all their placed orders, including cancellations, executed orders and quotations on trading venues and make these available to regulators on request. They will also have to provide the authorities with more information about their trading strategies and algorithms. This increased transparency will help increase market cleanliness. Firms that provide direct market access will have to ensure that their clients meet both regulatory requirements and trading venue rules. New obligations will also be placed on trading venues to monitor and control the incidence of HFT. Importantly, such trading may be discouraged as trading venues will be able to adjust their fees for cancelled orders according to the length of time for which an order was maintained and to calibrate them to each financial instrument. Some venues may even be allowed by market authorities to charge higher fees for orders that are subsequently cancelled, as well as on HFT traders generally, to reflect the additional burden placed on trading systems.

So what will the effect be? Given the increased regulatory burden there may be fewer participants in the market with a knock-on effect on levels of market liquidity.

As part of the implementation of MiFid II, the European Securities and Markets Authority has consulted on and is drafting regulatory technical standards which will set out the detail of these requirements and how they will apply in practice, in particular determining who will be defined as a HFT under the regulations. These are due to be submitted to the commission for approval by 3 July 2015.

In short, the behaviours revealed in recent weeks may well be less common in future.

Brian McDonnell is a partner in the financial regulation team of corporate law firm Addleshaw Goddard