The rules that surround algorithmic trading are increasing compliance activity in the front offices of trading banks and other firms on an unprecedented scale. It remains to be seen whether the current measures will create harmony or discord, writes David Hayes, an associate at CCL, the compliance consultancy.

Not every financial regulatory discussion is given the time allotted to high-frequency trading. The implications of automated trading have been under scrutiny on both sides of the Atlantic for some time, especially since the G20 issued the revolutionary pronouncement that there should be no unregulated financial market and no unregulated financial product.

One of MiFID (Markets in Financial Instruments Directive) II's central aims is to develop stronger rules to govern high-frequency trading. The idea is to oblige high-frequency trading firms to follow a set of 'best practices' and subject then to appropriate controls and oversight. The European Union, from which MiFID comes, also wants to require regulators to license those firms in the same way as brokers.

A seismic shift in compliance

Within Europe, MiFID II (along with the Market Abuse Regulation, or MAR) is expected to create a seismic shift in compliance. Indeed, the compliance function will become a different beast at high-frequency trading firms after 2017. Compliance officers will have to 'sign off' on all algorithms and be responsible for the regulatory requirement for trading surveillance to prevent 'market manipulation behaviours' – and this is irrespective of the size of the firm.

The problem for regulators has always been that regulation should preserve the benefits but mitigate the risks of trading; if they over-regulate, they know that liquidity will disappear.

The American CFTC (Commodity Futures Trading Commission) is also looking closely at high-frequency trading, taking much of its inspiration from MiFID II. Rule 575 issued by the CME Group (an American futures company and one of the largest options and futures exchanges) on the subject of disruptive trading states that traders can only enter orders with the purpose of executing them. Even though this sounds fairly harmless, it becomes extremely potent when we consider that many trading schemes rely on cancelling orders before they are executed.

From MAD to MAR

The aforementioned MAR is replacing the Market Abuse Directive (MAD), which has been in force since October 2004. MAR is meant to lead to a standardisation of rules throughout the EU and, along with the Criminal Sanctions for Market Abuse Directive (CSMAD), will come into effect in July 2016 (although the UK has not yet opted-in to CSMAD). Along with MiFID II there is no transitional period – firms need to comply on Day One.

MAR seems to admit that algorithmic or high-frequency trading strategies can be intrinsically abusive. The market abuse associated with high-frequency trading is typically caught by manipulating transactions or behaviours that relate to ‘financial instruments’: that is admitted to trading, applied for admission or traded on an in-scope market; or whose price / value depends on, or has an effect on, the price or value of financial instruments.

Examples of manipulating behaviours relates to placing, cancelling, or modifying orders which either disrupt or delay the functioning of the trading system; make it more difficult for others to identify genuine orders; overload or destabilise the system; or are intended to initiate or exacerbate a trend.

Indications of market manipulation

MAR Annex I has a list of indications or 'indicators' of market manipulation. They do not constitute market manipulation in themselves, but should be taken into account by market participants and regulators when they are considering transactions or orders to trade. It is on this non-exhaustive list of practices that the European Securities Markets Authority has conducted a consultative exercise (the deadline for replies was 15th October 2014).

Examples include the following practices.

• ‘Quote-stuffing’ (entering large numbers of orders to trade and/or cancellation and/or updates to orders to trade, creating uncertainty for other participants, slowing down their processes and/or camouflaging one's strategy).
• ‘Momentum Ignition’ (entering orders to trade, whether or not executed, intended to start or exacerbate a trend and to encourage other participants to accelerate or exacerbate the trend in order to create an opportunity to close out/open a position at a favourable price).
• ‘Layering and Spoofing’ (submitting many or large orders to trade often slightly away from the market and on one side of the order book in order to execute a trade on the other side, or removing the orders with no intention to execute).

True intentions

This links directly back to MiFID II and will encourage trading venues to impose fees on firms that have a high rate of cancellations. The ESMA consultative document says: ‘Trading venues shall establish economic penalties that are effectively a deterrent and ensure that these penalties are adequately and effectively implemented.’

Obviously, it is always difficult to determine the intentions of traders and work out whether submitted orders were meant to be executed, but new technology makes it easier in some ways to do so. In the old days of 'open outcry' trading floors, the trader carried his strategy in his head and it was not available to scrutiny, but today’s trading strategies are well documented in the source code and in the audit trails, explicitly naming all trading signals and the corresponding reactions.

That gives the regulator a much better chance of deciphering a trader’s true intentions, even in a complex world like ours.