On 28 September 2021, the European Securities and Markets Authority (ESMA) published its final MiFID II/MiFIR review report on algorithmic trading. The report covers a comprehensive range of topics, including high frequency trading (HFT) and high intraday message rates, Direct Electronic Access (DEA), third-country firms, organisational requirements for investment firms and for trading venues, as well as tick sizes, market making, asymmetric speedbumps and trade feeds. While the overall conclusion of the report is that the regulatory framework for algorithmic trading as set out by MiFID II and MiFIR has delivered its objectives, ESMA makes some recommendations for targeted amendments to the regime. Some of these should be of particular interest to those market participants engaging in algo/HFT on European trading venues but who themselves are located outside the EU – including in the UK.
DEA and third-country firms
ESMA notes in its report that the current MiFID framework does not require third-country firms having DEA to European trading venues to get authorised as investment firms. This is in contrast to those Tier 1 DEA users established in the EU who exclusively deal on own account and would otherwise be eligible for Article 2(1)(d) MiFID II exemption. ESMA expressed its view that the costs of requiring full authorisation of a person dealing on own account as an investment firm for the sole purpose of allowing that person to have DEA access, including as a Tier 1 client, outweigh the benefits expected from such authorisation. ESMA therefore proposes to delete the exception to the exemption from authorisation as an investment firm set out in Article 2(1)(d)(ii) MiFID II for persons having DEA access to a trading venue.
On the other hand, in respect of third-country firms ESMA notes that the lack of a harmonised EU regime for third-country firms creates an unlevel playing field between EU and non-EU firms, “with a competitive advantage provided to the latter”. This is reflected in the authorisation requirements applicable to EU firms having DEA to a trading venue – as described above – or applying HFT techniques. Conversely, ESMA notes that third-country firms engaging in similar activities “would only be subject to the applicable national regime, if any”. To this end, ESMA proposes to amend MiFID II provisions in a way that would require third-country HFT firms accessing EU trading venues to be authorised as investment firms, should they access EU trading venues through DEA or as a member or participant. That said, ESMA also considers that third-country HFT firms subject to an equivalent supervisory framework in their home country, should be allowed to access EU trading venues through DEA or as a member or participant without being authorised as an investment firm and to this end it suggests the development of a specific equivalence framework (in addition to the overall equivalence framework as foreseen by Article 46 MiFIR).
In addition to the DEA / third-country issues, some of the other recommendations put forward by ESMA include:
- Extension of algorithmic trading requirements to systematic internalisers (SIs): ESMA proposes to “selectively” extend some of the requirements to SIs, including – prospectively – (a) governance arrangements for trading systems and trading algorithms, (b) controlled deployment of algorithms and (c) a kill functionality and other risk controls.
- Algo-testing by investment firms: in order to reflect the need for flexibility in algo-testing, with a possibility to make tests more comparable, ESMA proposes to amend RTS 6 to have a principle-based testing regime, focused on outcomes.
- Circuit breakers: ESMA considers that more transparency from trading venues with respect to their circuit breaker mechanisms would be beneficial for the markets and it would allow market participants to better prepare for volatility events.
- Monitoring of compliance with trading venue rules: ESMA is of the view that “there is a need for coordinated effort between the industry and regulators to ensure the effects of an outage are as limited as possible and there is continuity of trading when there is an outage on the primary market”. To this end, it presents a number of proposals – legislative and non-legislative – that could help addressing the outage situations in the future.
- Market making arrangements: while ESMA concludes that the current market making regulatory framework works well, it also sees merit in a further simplification of the market making requirements in order to “benefit the resilience of liquidity”.
In terms of next steps, the report will be submitted to the European Commission for its consideration in the context of a broader upcoming MiFID II and MiFIR review.