Blog

MiFID 2 or the Markets in Financial Instruments Directive II is a legally binding requirement that was enacted by the European Union in January 2018, which is aimed at promoting transparency, enhancing the protection of investors and controlling the markets throughout the region. This was a successor to MiFID I, which was introduced in 2007, and MiFID 2 encompassed a range of additional policies which altered Europe’s financial environment, and affected algorithms trading in particular.

To be more specific, MiFID II included a set of additional policies to cope with the increasing sophistication of the financial markets, particularly in relation to high-frequency and algorithmic trading. Algo traders in the EU have greater reporting and transparency and compliance requirements which are aimed at fostering better and efficient markets. This studies covers the fundamental aspects of MiFID II, algorithmic trading under this policy and provision of challenges and opportunities for algo traders in Europe.

Main Purposes of MiFID II

There are basic focuses that needed to be addressed when developing ROI including, the protection of investor interests. This was specifically in terms of increasing the level of clarity about the opaque nature of the markets. MiFID II introduced a number of key provisions which included pre-trade and post-trade transparency requirements across a wide variety of financial instruments, including equities and bonds, derivatives and commodities.

Investor Protection: MiFID II implemented tougher measures for product governance, disclosure, and suitability checks in order to safeguard the interests of retail and institutional investors. These measures were meant to aid investors better their decisions and to mitigate the conflicts of interest between brokers and advisers.

Mitigating Risks in High Frequency and Algo Trading: MiFID II takes into consideration the adverse impact that high-frequency trading as well as algorithmic trading factors presents. It placed significant restrictions on firms engaged in algorithmic trading, compelling risk controls to be more robust, and improved market surveillance and responsibility.

Improved Market Stability and Integrity: In order to ensure stability, MiFID II requires that firms undertaking financial activities establish systems and controls to avert market abuse, such as spoofing or layering (specific forms of market manipulation). This was intended to help foster fair and competitive trading.

Key Provisions of MiFID II Impacting Algorithmic Trading

Algorithmic and high-frequency trading activities were the focus of specific provisions introduced by MiFID II that include risk control measures, transparency and accountability mechanisms. The rules concerning the algo traders follow are presented below:

MiFID II Summary Algorithm Testing and Validation: All the firms which engage in algorithmic trading should conduct assessment and evaluation on a periodic basis. One way of determining such algorithms is by stress testing them in different conditions within the market to ensure they do not escalate market disruption. Likewise, any institution or firm is expected to possess procedures to disable any algorithm instantaneously where inappropriate behavior persists.

Just a few examples of rules imposed by MiFID II which are likely to affect Losers algorithm investors:

Why stock should trade: Look deeper than just charts to identify an algorithmic trader MiFID II Seattle trades for action: Enforcement? Without execution? No problems alone — OTR lower underpinnings exist and are readily acknowledged. OTR is a strong indicator of corporate order fragments which can be squandered by metric over obligations. Messages which constitute millisecond timings turn into drones and slack of data at congestion. With MiFID II such non-loophy circumstantial guidance planes are now consider marketing portions.

Algo Trading Registration and Monitoring: MiFID II states that companies involved in the automation of trade have to apply to the relevant competent authorities and register. It is also mandatory for the companies to keep trading data and present it for inspection on a regular basis to enforce compliance. All these measures help in enhancing accountability and traceability for algo trading actions.

Risk Controls and Circuit Breakers: The algo trading firms must include strong risk controls, one such being a circuit breaker, to avert market chaos. These controls are necessary as they lessen the risks that could be induced by stranded algorithms or spikes in trading volumes in a aimless direction which could facilitate flash crashes or volatility in the market.

Market Making and Liquidity Provision: MiFID II has established that such firms that do high frequency trading must be registered as market makers as long as they meet other predetermined conditions. This means they have to commit to guaranteeing the provision of liquidity during the market at designated time periods. This rule aims at trimming the effect “ghost liquidity” has in the market in order to enhance the market’s stability.

1. Increased Compliance Costs And Administrative Burdens

The compliance costs have notably been increased with the undertaking of such obligations concerning monitoring, record-keeping and transparency in general which requirements have been propagated by MiFID II. Algo trading firms must equip themselves with strong infrastructure, software and personnel in as much as compliance is concerned. It is likely that the smaller companies will find it hard to absorb such costs and hence a potential consolidation in the market may take place.

2. Effects as to how speed and strategic freedom have been affected

Certain fundamental principles, such as order to trade ratio and pre-trade/post-trade requirements, has its adverse effects to speed and/or agility of the strategies involved. Users of aggressive strategies that have tended to be volume and speed based are probably now looking for ways to comply with MiFID II’s requirements which presumably has changed how they model their strategies.

3. Fundamental principle of risk control being adopted

The attention to risk controls as well as the adoption of the circuit breakers has intensified the area of risk management of the algo trading strategies. It is also a requirement that firms should always be testing their algorithms in order to avoid any errors and disruptions of services. This has led to the need of better and sophisticated testing environments as well as additional security measures.

4. Improved Market Surveillance and Data Management

MiFID II requires the algorithmic trades to be recorded and monitored effectively, this makes it easier for regulators to curb market abuses. In the case of algo traders, this has made them have to invest highly in data management and monitoring systems since these operations are now a necessity rather than an option.

5. Consequences on HFTs and Market Makers

The firms which are engaged in high-frequency trading are the ones facing most impacts of the rules imposed through MiFID II. Due to constraints associated with OTR and the compulsory market maker registration, HFT firms suffer limited scope in their trading options. Nonetheless, the regulation does offer an opening for such firms to gain confidence by supporting the tenets of transparency and stability.

The Opportunities Brought Forth by MiFID II for HFT Firms

On the downside, MiFID II poses some challenges. However, it does extend some prospects as well:

Institutional Investors Can Partake In Algos With Less Fear Of Abuse Or Flash Crashes The improved market conditions due to enhanced transparency and accountability caused by MiFID II may have made the market conditions better. Institutional investors in the algo trading markets may now have a less fear of market abuse or flash crashes, and so decide to trade in such markets more actively.

A Growth In Compliance And Surveillance Tools There has been a growth in the need for compliance management that has consequently led to a growth and improvement in surveillance technology. These are tools which HFTs can use to not only strengthen their compliance, but also enhance its analysis and optimization for the purposes of trade strategy development.

Shift Towards Innovation in Low-Frequency Strategies The slowdown and volume restrictions have driven algo traders to delve into other models such as low and medium-frequency trading. Such strategies are less affected by OTR caps and are more appropriate for longer-term trading styles.

More Active Engagement with Regulatory Agencies Torres et al. (2015) argue that it is MiFID II that built the bridge between regulators and algo traders. By interacting with regulators, algo firms are in a position to avoid compliance grievances, set the best practices in the industry, and enhance their trading architecture.

Conclusion

From a European perspective, MiFID II clearly affected the business of algorithmic trading in Europe. The rules and regulations increased the control, accountability and required a level of transparency which large numbers of algo trading firms lacked, thus ensuring the firms became more responsible and cognizant of market manipulation practices. These changes while imposing compliance costs, changes to strategy, and operational burden on the firms also provide scope for improvement in risk management, advancement in technology, and build greater trust in the investors.

In the end MiFID II comes back to the issue of whether it is possible to foster development within algo trading while ensuring that honest and transparent markets are espoused. For the future there will be algo traders who understand these principles and will prosper in what will be a more compliant environment, but one that is more robust and sustainable.

To avail our algo tools or for custom algo requirements, visit our parent site Bluechipalgos.com