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MiFID II is European Union legislation that regulates firms that provide services to clients linked to financial instruments and the venues where those instruments are traded. The legislation introduces new rules and transaction reporting obligations that will go into effect on January 3, 2018. The rules are intended to:

  • Improve investor protection
  • Reduce the risks of a disorderly market
  • Reduce systemic risks
  • Increase the efficiency of financial markets and reduce unnecessary costs for participants

The rules affect Direct Electronic Access (DEA), algorithmic trading, high frequency trading (HFT) and market making and introduce very specific transaction reporting requirements.

MiFID II defines algorithmic trading as trading in financial instruments where a computer algorithm automatically determines individual parameters of orders, such as 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.

MiFID II defines DEA as an arrangement where a trading venue member, participant or client permits a person to use their trading code to electronically transmit orders relating to a financial instrument directly to the trading venue.

Transaction Reporting Requirements

As a means to provide the level of transparency required under MiFID II, ESMA has mandated transactional reporting requirements whereby investment firms must report their transactions, with very specific information, to the appropriate regulatory bodies on a T+1 basis.

To facilitate these requirements, exchanges and other trading venues are supplying fields in their API specifications for electronic trading that adhere to the new regulations. Fields that must be populated on each order (on a pre- and post-trade basis) by all firms providing DEA include but are not limited to:

  • Direct Electronic Access: Indication of whether or not the order is DEA.
  • Trading Capacity: Indication of a dealing on own account, matched principal and any other capacity.
  • Liquidity Provision: Indication of market making.
  • Commodity Derivative Indicator: Indication of whether the order is for hedging purposes.
  • Investment Decision: Indication of who made the trading decision.
  • Execution Decision: Indication of who (or what algo if applicable) submitted the order.
  • Client: Indication of the customer (LEI/Short Code).

Additionally, investment firms must include timestamps that are synchronized to global GPS. The timestamps on all HFT orders must have microsecond level precision, and timestamps for non-HFT orders must have millisecond level precision.

Algorithmic Trading Requirements

Investment firms have several obligations related to the use of algorithmic trading, HFT and market making including but not limited to:

  • All algos, whether developed by the firm, a client, a vendor or anyone else, must be tested and registered with the appropriate trading venue.
  • Firms must stress test algos by running high message and trade volume tests and ensure that algos will not result in disorderly markets.
  • All orders sent by an algo must be sent with an ID that represents the algo registration ID.
    If there is a material change to an algo, the details must be recorded and the algo must be re-versioned and re-registered with a new identifier.
  • Firm administrators must be able to control access to algos that have been properly tested.
  • Firms must have pre-trade risk controls, including price collars, position limits and message limits, among others, in place for each instance of every algo.
  • Firms must continuously monitor credit and market risk exposure and be able to fully stop running algos.