On July 20, 2011, the European Securities and Markets Authority (ESMA) issued a consultation paper on systems and controls relating to high frequency trading (HFT) and other forms of automated trading. ESMA is a newly established European authority with the remit to work on and establish legislation and regulation in the EU to standardize markets and monitor/resolve systemic risks for investors and market participants.
“Consultation on the Guidelines on systems and controls in a highly automated trading environment for trading platforms, investment firms and competent authorities” (the Consultation) sets out ESMA’s proposals for detailed guidelines for trading platforms, investment firms and regulators to address HFT and other challenges of a highly automated trading environment. ESMA states that the guidelines are intended to clarify the obligations of trading platforms and investment firms under the existing EU legislative framework (i.e., where no legislative changes are required). It believes that the proposed guidelines “contribute to the efficiency, orderly functioning and resilience of trading in a highly automated environment.” The Consultation follows on from certain of the issues addressed in the April 2010 calling for evidence by CESR (ESMA’s predecessor) on micro-structural issues of the European equity markets. This sought information on HFT, sponsored access (SA), co-location services, fee structures, tick size regimes and indications of interest.
The Consultation sets out and explains the draft guidelines on requirements that are considered to be relevant in a highly automated trading environment for electronic trading systems, fair and orderly trading and dealing with market abuse (in particular market manipulation). There are separate standards in each of these areas for trading platforms (which includes both regulated markets and multilateral trading facilities) and investment firms executing orders on behalf of clients and/or dealing on their own account. The final section sets out and explains the draft guidelines covering direct market access (DMA) and SA. While the terms “DMA” and “SA” both are used in the Consultation (and in this Advisory as a result), in practice there is no real distinction between the two. The guidelines are separate from the work the European Commission is conducting in related areas as part of its proposals to revise the EU Markets in Financial Instruments Directive (MiFID). Therefore, while the Consultation relates to EU-regulated markets and MTFs, and firms authorized and regulated by one or more EU regulators, the issues it raises (and the guidelines proposed) are relevant to all HFT or algorithmic traders. Recent IOSCO and other non-EU regulators’ releases, for example, have focused on similar concerns.
The Consultation does not propose guidelines for co-location, fee structures or tick sizes, since these topics do not relate directly to systems and controls.
2. Summary of the Guidelines
This Advisory provides a summary of the guidelines that we believe to be of particular importance. The guidelines are wide in scope and cover compliance obligations, risk management systems, the development and testing of strategies and trading platforms, and clearance and settlement, among other things, and are expressed to constitute a minimum standard of policies/procedures. Our summary does not include every guideline and we urge clients affected by the guidelines to read the Consultation.
It is our view that the training of personnel and the clear separation of roles for certain functions within a firm will become more important. As well, there are significant areas where regulators will expect firms to have written procedures and controls for compliance and financial risk. These written procedures and controls will be subject to scrutiny by regulators and other firms (e.g., trading firms that have DMA will need to make information available to the firm providing such access) in the future. Finally, firms must be prepared to demonstrate that they have a rigorous testing for trading systems and algorithms in a test environment.
Katten’s Proprietary Trading Practice (PTP) is preparing with its clients a number of policies/procedures that are designed to satisfy the guidelines. The firm also can provide training on preventing market abuse and market manipulation and maintaining orderly/fair markets, as well as assistance on any particular platform rules.
3. The Guidelines
Not all guidelines for trading platforms apply to investment firms. Please note that we have highlighted where the guidelines under each of paragraphs 3.1, 3.2 and 3.3 below apply to both trading platforms and investment firms.
3.1 Organizational requirements for electronic trading systems
(a) Trading platforms
Trading platforms should:
(b) Investment firms
Investment firms should:
3.2 Organizational requirements to promote fair and orderly trading
3.3 Organizational requirements to prevent market abuse/manipulation
3.4 Organizational requirements for DMA/SA
The consultation period ends on October 3, 2011, and ESMA expects to publish its final guidelines before the end of the year. We encourage all parties interested in HFT to respond to the Consultation. Please contact any of the members of the PTP, in particular those listed on this Advisory, if you have any questions concerning ESMA’s consultation paper.