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International Regulations
In the following chapter, I describe how algorithmic trading and high frequency trading are regulated by the European Commission (EC), the European Security and Market Authority (ESMA) and the directives by the Market in Financial Instrument Directive (MiFID). This chapter will also highlight the proposed directives and regulations target-ing AT and HFT released the 20 October, 2010 in Brussel by the EC.
Regulatory initiatives on manipulative trading practices
The markets have change rapidly on a worldwide scale recent years, an increasing automated order systems is one of the main shifts. U.S. and European securities regulators have tried to adjust their current regulations to better suit market abuse. The European Commission (EC) adopted new market abuse regulations (MAR) in October, 2011, which replaced the Market abuse directive from 2003. The market abuse regulations recognized that the existing regulations on market manipulation were very broad and capable to apply on abusive behavior (Solomon, M. 2012). However, they decided to determine suitable specific examples in the new MAR of strategies using HFT and AT that falls within the proscription against market manipulation and market abuse. In order ensure a consistent approach in monitoring and implementation by regulatory authorities, article 8 of the mar-ket access regulation (MAR) exemplify a thorough list of techniques that could be used to manipulate and abuse the market, including sending order to a market place without the intension to actually trade, but instead for the purpose of Delaying or disrupting the operational of the trading system of the trading ven-ue.
Making it more difficult for other investors to identify real orders on the trading system of the trading venue; or
Creating a misleading or false impression regarding the supply of or demand for a financial instrument. (Source: Solomon, M. 2012)
The European Securities and markets Authority (ESMA) highlighted in December, 2011 in its guidelines regarding systems and controls, a list of possible cases of market manipula-tion that could be of vital concern in an automated trading place. (Solomon, M. 2012).
EU Regulations
The European security and Market Authority (ESMA) released a so called, consultation paper in 2011. The consulting paper states several guidelines on systems and controls in a developed automated trading environment for all trading venues, all investment firms and all nations competent authorities. (ESMA/2011/224). The questions about HFT and algo-rithmic trading have been highlighted on European level during recent years and this con-sulting paper is of interest of regulatory markets and trading facilities, investment firms executing orders on behalf of clients, particularly when business models including auto-mated trading or provides direct market access the their clients, as well as HFT traders in-directly or directly accessing European markets.
On page 53 ESMA state that the development of AT and direct access to market places is perceived to have created risk to the following regulatory objectives:
Investors protection: Investor may take external risks that they are not aware of when trad-ing in a market relying on AT. More generally, market stability and integrity may have consequences for them if the AT doubtfully interacts with the market (ESMA/2011/224).
Market integrity: insufficient protection of abusive behavior and fraud may decrease the number of participant in the market by weakening their confidence that they will be equal-ly treated when using markets (ESMA/2011/224). If the trading activity decreases it may lead to higher transaction costs on secondary markets, which in turn could increase the cost of raising capital through financial instruments on European markets.
Financial stability: Disturbance of secondary market has consequences on the providing of liquidity and the forming of public prices. This may lead to problem for individual institu-tions and might cause moments of stress in financial markets with consequences for the functioning of intermediaries in the financial market as a whole (ESMA/2011/224).
MIFID Regulation
Market in Financial Instruments Directive, MiFID, was implemented in Swedish law in 2007 and replaced the existing investment Service Directive (ISD) from 1993. The new directive was designed to enable increase level cross- broader transactions, and after im-plementation, would enable trading throughout the European Union (EU) to become more efficient, cheaper and quicker and will offer greater protection to investors (Karande. 2007).
MiFID will set a broad regulatory system, implement high standards and include com-modity derivatives. It will therefore generated greater harmonization of European laws and induce capital market integration in the EU (Karande.2007).
The goal of the directives is to guarantee that intermediaries and investors can connect feely with clines in other EU areas (including Norway, Switzerland and Lichtenstein) on same terms and conditions as in their home country. Issuers should be able to trade at deeper and more liquid markets with lower transaction costa and spread as well as cost of raising capital (Karande. 2007).
The implementation of MiFID was important, if not critical, for the occurrence of HFT and algorithmic trading. Debates and research within the EU-Commission aims to determine whether MiFID need to be completed and also if there are reasons to expand regulations because of developments in financial markets. It should be noted that a review of MiFID was already planned when it were introduced in 2007, and is therefore not a reaction of events and development after 2007 (Johansson, N. 2012).
MIFID II Regulation
The management and control of algorithmic trading and high frequency trading is new in the commission’s proposal of revision of MiFID, the proposal consists of two part, first a proposal of modify directives and, second, a regulatory framework, both were released the 20 October, 2010 in Brussels by the European Commission.
The primary objective has been to further the competitiveness, integration and efficiency of European financial markets. It enables a wide free competition between traditional ex-changes and alternative venues, and eliminates the opportunity for nations within EU to entail all trading in financial instrument to take place on specific venues. Further the com-mission states that the increased technological advances have increased the speed and complexity of how investors trade.
These technological improvements has implied advantages in general meaning through higher participation, higher liquidity, a smaller spread, lower short-time volatility and in-creased possibility of order execution. However, the commission also notes that the tech-nology also raises some concerns; such as higher pressure of systems, risk of incorrect order placement (Market abuse) which in turn may lead to turbulence market conditions. The commission also believes that algorithmic trading can give rise to over reaction to market events, which increases volatility and if it’s abused, can lead to impropriate market fluctuations.
The commission believes that these problems are best tackled through measures directed at both active companies and against the regulated marketplaces at which they operate. Hence, the commission suggests that company active in high frequency trading or investors using HFT should be under supervision if they have direct access to a market-place. This technological development in exchange places both creates challenges and opportunities, which has led to a more efficiency market and the generally opinion is that liquidity has increased, regulatory and supervisory measures is of significant importance in order to successfully deal with potential threats for the functioning of market arising from algorithmic trading and high frequency trading (EU-proposal, 2010).
In generally, the proposal aim to bring all investors engaged in HFT into MiFID, and re-quiring suitable safeguards from these companies and those offering access to other high frequency traders, and demand venues to implement risk control to make sure the resilien-cy of their platforms. Further, the proposal also aim to assist the monitoring and oversight of such activates by competent authorities.
The proposed directives for actors using algorithmic trading are relatively extensive. Ini-tially suggesting that companies active in algorithmic trading have to use effective systems and some sort of risk control, to ensure that the system have sufficient capacity and resili-ence to deal with peak orders and condition of market stress.
Furthermore, the system need to have circuit breaker and limits to make sure that algorith-mic trading system cannot contribute or create to disorderly trading circumstances to mar-kets including systems to limit the ration of unexecuted orders to transactions that may be entered by a member or participant (Article 51, EU commission, 2010). In addition to this, the companies shall ensure that their systems cannot be used in a way of market manipula-tive activity or for violation of the rules regarding participation in trade at market places.
Finally, the commission states that companies shall have contingency measures available to tackle failures of the system and that the system beyond this will be adequate tested and supervised.
Articles 17 in the proposed directives is one of the most comprehensive articles and is spe-cifically regarding algorithmic trading.
An investment firm that participates in algorithmic trading shall at least once a year pro-vide to their nations home Competent Authority an extensive description on their AT strat-egies, details regarding trading constraints or limits to which the system is subject (Article 17 (2) EU-commission, 2010), the key compliance and risk controls that make sure the condition are fulfilled and details of performed system tests. The home competent authori-ty can at any time in-between request further information about the system used for trading and about an investment firms trading strategies.
An investment firm that also acts as a cleaning member for other investors shall have en-sure that cleaning services are only useful to persons who are seen as appropriate and meet proposed standards, further the firms shall also make sure that appropriate requirement are imposed on those investors in order to reduce risk to both the investment firm and the mar-ket. The investment firms shall further have in place effective systems and make sure that they have written binding agreements between the investor and the company concerning vital rights and responsibilities arising from the providing of that service (Article 17 (5) EU-commission, 2010).
The investment firm are obligated to make sure that the firm and investor retains responsi-bility for that the traders using that service achieves the requirement of this instructions, the regulation (EU) (MAR) and also the rules of the exchange.
An AT strategy shall be operating throughout all the hours of the trading venue to which it sends order to or the system which performs the transactions. The constraints or limits of an AT strategy shall make sure that the strategy provides competitive prices with the result of supplying liquidity on an constant basis to the venues at all times, notwithstanding cur-rent market conditions.
In article 17 (4) the commission further state that an investment firms that delivers direct electronic access to a trading venues need to have controls and effective systems which confirm the suitability of the investor using the servicer, preventing the investor to exceeding suitable trading and credit thresholds, that the investor using the services are is correctly supervised and that suitable risk controls prevent abusive trading that may gener-ate unnecessary risk for the investment firm itself and which may contribute to disorderly market or are against rules of the venue. As mentioned above the commission believes that these problems are most efficiently tackled through measures against both active firms and against
regulated marketplaces at which they operate. An extended responsibility have been im-pose on the algorithmic trader interaction with market, thus the proposal also aims to im-pose restrictions on marketplaces as well.
In Article 51 the commission poses different points regarding member states regarding systems resilience, circuit breakers and electronic trading. The first point state that all Eu-ropean Union member states shall require a well regulated market to have in place suitable systems, arrangements and procedures to make sure its trading systems are strong, and have satisfactory capacity to deal with high volumes of order and message volumes and are able to ensure, that under condition of market stress an well orderly trading environment exist (Article 51 (1) EU commission, 2010). Further all member states shall have in place suitable systems, arrangements and procedure in order to make sure that AT cannot create or contribute to disorganized trading circumstances (Article 51 (2) EU commission, 2010). A regulated market that supplies direct electronic access shall have suitable systems to make sure that investors and members are only allowed to offer services if they are an official investment firm. The investment firms have to be under this directive, make sure that suitable criteria are met concerning the appropriateness of investor who have access and that the member or investor retains responsibility for order executed (Article 51 (3, 4), EU-Commission, 2010).
The commission also states that upon demand from the competent authority a regulated market shall make order book available or give the competent authority access availability in order to be able to monitor the trading.
The directives of the so called OTF (organized trading facilities) are new directives to the MIFID. OTF is a trading platform which is more or less the same as all the other, except one vital aspect. The organization of the platform has the right to determine who will be admitted to trade (Johansson, N. 2012). With the constraint that such trade will take place on competitively neutral terms. Also, the one who executes trade may not be able to trade it against his own stocks, since OTF cannot have any connection with other OTF whereby terminates the possibility of orders can be made against each other.
The directive for OTF will also be applicable for the present crossing Networks and dark pools. Another significant detail of the directive is that the supplicant for an OTF market needs to declare why the trade cannot be executed on a regulated market venue or a MTF (Johansson, N. 2012).
Research Method
To investigate and understand the meaning of algorithmic trading in Swedish market, which is the objective of this thesis, a survey is used to obtain further information regard-ing fairness, ethics and responsibility in Swedish markets, questions about new regulations and integration in markets will also be used. A qualitative research method through an E-mail-based questionnaire is applied in order to give the participators an opportunity to freely discuss and analyze the questions as much as they wish. In this research the opinions and the responses from participators in the survey will be the content of my empirical in-formation.
Identifying suitable contacts
In order to identify a number of suitable organization that matches my criteria for the types of business that I wish to include in this research, I contacted the Swedish financial institu-tions (FI) and ask for contact list for all firms that participated in the report made by FI during 2011 (See 2.5). In some cases the contacts that I received were direct too the partic-ipator in the report made in 2011 (see, 2.5). In some firms their shifting organizational structure made it difficult to track down the most appropriated employee to contact. First I made a direct approach through telephone to all firms before deciding how were the most suitable persons in relation to my specific research (Saunders et al, 2012). My objective of making a direct request through telephone was to make it harder for them to turn me down, than through a non-personal contact as E-mail. All my responders are either head of com-pliance, head of capital market or a stockbroker on their respective firm, so I am satisfied with the competence of my participators. All my responder`s business differs slightly, by capture the different aspects of their situation and views enable me to find differences of interest but also common factors. The common factors are that they all have contact with regulations on exchanges, and trades on stock exchanges on a daily basis.
Questionnaire design and structure
In my research I used a self-completed internet based questionnaire were the respondents are the one to complete the questionnaires. This kind of questionnaire design are common-ly used for descriptive or explanatory research, and in my case for both (Saunders et al,), the objective behind my choice of research design is to make sure that I reach out to a par-ticular person as respondent and the objective of a self-administrated open ended question is to give the respondent an chance to analyses and answer in a suitable way for each cho-sen firm.
When structuring my questionnaire I needed to be clear and define precisely what data I wanted to collect. I choose to have 4 main parts of my questionnaire to give them a clear and consistent picture of what specific subject related to those specific questions (see ap-pendix). Since there are many factors too take into consideration when investigating how ting automated trading systems should work on financial stock markets, all part had an title to show the responder in what way he or she should interpret the questions, this were made in order to make sure that my questionnaire actually represents the reality of what I were measuring (Saunders et al, 2012).
Delivering and collection the questionnaires
In an attempt to maximize my response rate I have taken some actions, First I made sure that my questionnaire were well designed and well-structured to give the participator a seriously impression, second, I decided from the beginning two have a total of five con-tacts with my participators in order to make them feel important and to show my gratitude. First contact were med by telephone, short information were given and they had their chance to ask me thing as well, second contact were a pre-survey mail, thanking them and some short facts about the timeframe and some guidelines in how to fill in the question-naire, third contact were made through email with the actually questionnaire attracted and my contact number if any further questions were raised, the forth contact were made after one week after they received the questionnaire and thanked early respondents and encour-age non-respondents to fill in the questionnaire, a last contact with the results from the questionnaire. All does steps are in order to support and encourage them to fill in the ques-tionnaire and contribute to my research.
Method Critic
Since my research method where an e-mail based questionnaire with open ended question a lot of pressure were put on the respondents in order to give me good and valid infor-mation, this turned out to be a great method, since a majority of the respondents analyzed all questions to large extent. However, the persons I choose to contact needed to be of sig-nificant importance and be able to contribute to my specific research questions. Despite my ambitious five contacts with encouragements many of my respondent to large extend ig-nore my emails, this is advantage of not having a face to face interview were I receive the answers straight away. The possibility of the respondent to only make short answers were also a negative effect of the use of an E-mail based questionnaire, however, the majority of the respondent did analyzed and answers my questions in a trustworthy way. The problem of bias always is always present, interview bias is when the respondents choose to not an-swer in a trust fully way, instead the respondents might give a picture of the situation in a negative or positive fashion. All my respondents have daily interference with HFT and AT and therefore them all seen suitable for my research. However bias always exist, but in my research the respondent have separated opinions related to HFT so I believe that bias have not influenced the final result to significant extent.
Table of Contents
1 Introduction
1.1 Background
1.2 Purpose
1.3 Methodology and Data
1.4 Delimitations
2 Literature Review and Theory
2.1 High frequency trading changed global markets
2.2 Flash Crash
2.3 High Frequency Trading manipulation strategies
2.4 Ethical decision factors
2.5 High Frequency trading in The Swedish market
2.6 Evidence from research on the effects of algorithmic trading and HFT on market quality
2.7 Theory
3 International Regulations
Regulatory initiatives on manipulative trading practices
3.1 EU Regulation
4 Research Method
4.1 Identifying suitable contacts
4.2 Questionnaire design and structure
4.3 Delivering and collection the questionnaires
4.4 Method Critic
4.5 Respondent profiles
5 Empirical results
5.1 Summary of the responses
6 Analysis
7 Conclusions
8 Discussion and Further Research
8.1 Academic References
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