MiFID II: Regulating High Frequency Trading, Other Forms of Algorithmic Trading and Direct Electronic Market Access

Abstract

So is flash trading good or bad for the market? Michael Lewis, in his recent book Flash Boys – Cracking the Money Code, paints a far from positive picture of high frequency trading. Flash traders use such advanced techniques that the rest of the market is left trailing in their wake. But, as was to be expected, not everyone agrees with his analysis. The Markets in Financial Instruments Directive II (MiFID II), which will become binding on the financial sector in the EU/EER as per 3 january 2018, adopts a middle course: it does not prohibit high frequency trading, but it does subject it and other forms of algorithmic trading to specific supervision as they entail specific risks. High frequency trading and other forms of algorithmic trading are not alone in being subjected to a supervision regime in MiFID II. What is now the fairly common practice of investment firms in providing their clients with direct electronic access (DEA) to perform transactions is also subjected to a specific form of supervision. Providers of DEA are now required to ensure that this access complies with the appropriate systems and risk controls. The link between high frequency trading and other forms of algorithmic trading on the one hand and DEA on the other is dealt with later in this article. These are all important regulatory innovations as high frequency trading and other forms of algorithmic trading and DEA are not subjected to specific rules of supervision in MiFID I. Nonetheless, the rules in MiFID II are not entirely new. To a large extent they are based on and amplify the ESMA Guidelines entitled Systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities. However, as the rules have been formalised through inclusion in MiFID II, the supervision of flash trading and other forms of algorithmic trading now figures more prominently on the agenda of the supervisory authorities. This article discusses the themes noted above from the perspective of MiFID II/MiFIR.