Editor’s Note: Federal agencies can benefit from studying foreign regulators’ work before deciding to undertake their own regulatory experiments.
Article by Gunnar Schuster and Alexandra Dreibus
The German Parliament adopted new regulatory requirements for algorithmic and high frequency trading. In the future, high frequency traders on German regulated markets or MTFs will be subject to a license requirement.
On 28 February 2013 the German Parliament adopted the High Frequency Trading Act (Hochfrequenzhandelsgesetz, the HFT Act). The HFT Act introduces a license requirement for high frequency traders, imposes conduct of business rules and organisational requirements for algorithmic trading and specifies the definition of market abuse. To a large extent these regulatory requirements anticipate regulations that are currently discussed on the European level in the context of the revision of the Markets in Financial Instruments Directive (MiFID II) and the Market Abuse Directive. Most of the provisions in the HFT Act will come into force following its publication in the German Federal Gazette which we expect within the next weeks.
License requirement for high frequency traders
High frequency traders, irrespective of their location, will be licensable by the German Federal Financial Services Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) if they are a direct or indirect participant of a German regulated market or MTF. The licensable service is described as buying or selling financial instruments for own account as a direct or indirect participant of a domestic regulated market or MTF by a high frequency algorithmic trading technique characterised by the use of infrastructure intended to minimise latencies, by automated order initiation, generating, routing or execution without human intervention for individual trades or orders and by a high volume of intraday messages which constitute orders, quotes or cancellations.
The HFT Act does not define under which circumstances a person qualifies as an indirect participant of a German regulated market or MTF. According to the explanatory memorandum of the German government
This refers to persons that have a direct electronic access through a member or participant of a German regulated market or MTF. Electronic access means an agreement with such a member or participant that allows a person to use the trading ID of the member or participant for direct electronic order transmission to the trading venue. The explanatory memorandum does not contain any further distinctions of electronic access arrangements like Direct Market Access and Sponsored Access which are mentioned by ESMA.1
Also persons or entities not having a physical presence in Germany can be subject to the obligation to obtain a license from the BaFin. Foreign high frequency traders authorised as a credit institution or investment firm in the EU/EEA could rely on a MiFID passport provided their license includes dealing on own account as defined in Annex I A 3 of the MiFID. On a case by case basis the BaFin may waive the license requirement for entities that cannot rely on a MiFID passport or that are domiciled outside the EU/EEA, if in the view of the BaFin the entity, due to the nature of its business and comparable regulation in its home country, does not require a supervision by the BaFin. Entities that are domiciled outside Germany and cannot rely on a MiFID passport or a waiver regarding their high frequency trading activity have to apply for the license within nine months following publication of the HFT Act in the German Federal Gazette. These entities will have to establish a German branch or a German subsidiary to apply for the licences. German entities that are subject to the license requirement have to submit their application within six months. Entities that apply for a license for high frequency trading must have an initial capital of at least €730,000. They must appoint at least one reliable and appropriately qualified managing director.
Conduct of business and organisational rules
The HFT Act introduces conduct of business rules and organisational requirements both for algorithmic traders and operators of German trading venues.
Algorithmic trading is defined as trading in financial instruments where a computer algorithm automatically determines the individual parameters of orders, excluding systems that are only used for the purpose of routing orders to one or more trading venues or for the confirmation of orders. Individual parameters of orders include in particular decisions whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention.
Requirements for algorithmic traders
Domestic investment firms, fund management companies and investment corporations that engage in algorithmic trading have to comply with additional organisational requirements regarding their trading systems (including business continuity systems) and risk management. They shall ensure that their systems do not create or contribute to market disruptions and cannot be used for activities violating European or domestic market abuse prohibitions or rules of the trading venue. Changes of computer algorithms used for trading must be documented.
Requirements for trading venues
Operators of German regulated markets and MTFs have to update their rules to ensure that participants earmark orders generated by algorithmic trading including the relevant trading algorithm. They shall impose special fees for an extensive use of the systems for transmissions, amendments and cancellations of orders. Moreover, appropriate measures have to be taken to ensure orderly fixing of prices in case of significant volatility.
Participants of German regulated markets and MTFs must ensure an adequate ratio between their orders and executed transactions. The order-transaction ratio will be determined separately for each financial instrument based on the volume of orders and transactions per month. The order- transaction ratio is considered appropriate if it is ‘economically comprehensible’ in light of the liquidity of the respective financial instrument, the specific market conditions or the function of the participant.
Operators of regulated markets and MTFs must introduce appropriate minimum tick sizes for each financial instrument. A comparable duty is imposed on systematic internalisers. The requirement shall stop a current trend to further reduce minimum tick sizes which goes along with an increased splitting of orders.
Enforcement powers of supervisory Authorities
The introduction of new conduct of business rules for participants of German trading venues is accompanied by an enhancement of the enforcement powers of supervisory authorities. The information rights of exchange supervisory authorities are extended to indirect participants of German regulated markets. They include the right to request detailed information on algorithmic trading. The BaFin is granted similar information rights vis-à-vis investment firms that engage in algorithmic trading. To ensure orderly trading an exchange supervisory authority may also prohibit the use of an algorithmic trading strategy.
Definition of market abuse
The HFT Act will also add the following clarification to the rules specifying the prohibition of market abuse: The placing of purchase or sale orders to a market by means of a computer algorithm which automatically determines the parameters of the order could be considered market abuse provided the placing of orders occurs without a trading intention, but (a) to disrupt or delay the functioning of the trading system, (b) to make it more difficult for a third party to identify genuine purchase or sale orders in the trading system, or (c) to create a false or misleading signal about the supply of or demand for a financial instrument.
1.ESMA, Guidelines: Systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities, 24 February 2012, ESMA/2012/122.