|European Union Electricity Market Glossary|
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Algorithmic trading is trading done using computer programmes applying algorithms, which determine various aspects including price and quantity of orders, and most of the time placing them without human intervention.
Legal definition is comprised in Article 4(1)(39) of MiFID II, pursuant to which algorithmic trading is "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, and does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions."
Article 18 of the Commission Delegated Regulation (EU) 2017/565 of 25 April 2016 explains a system is considered as having no or limited human intervention where, for any order or quote generation process or any process to optimise order-execution, an automated system makes decisions at any of the stages of initiating, generating, routing or executing orders or quotes according to pre-determined parameters.
Algorithmic trading includes arrangements where the system makes decisions, other than only determining the trading venue or venues on which the order should be submitted, at any stage of the trading processes including at the stage of initiating, generating, routing or executing orders (Recital 21 of the said Commission Delegated Regulation 2017/565).
Hence, algorithmic trading encompasses not only the automatic generation of orders but also the optimisation of order-execution processes by automated means.
Interestingly, even the use of a relatively simple algorithm qualifies as algorithmic trading in the light of MiFID rules.
According to the ESMA clarification of 19 December 2016 (Questions and Answers on MiFID II and MiFIR market structures topics, ESMA/2016/1583) "the fact that a person or firm undertakes trading activity by means of an algorithm which includes a small number of processes (e.g. makes quotes that replicate the prices made by a trading venue) does not disqualify the firm running such algorithm from being engaged in algorithmic trading."
Conversely, if an investment firm merely transmits a client's order for execution to another investment firm who uses algorithmic trading, the transmitting investment firm is not engaged in algorithmic trading.
There is explicit confirmation from ESMA in the said Q&As that "the transmission of an order for execution to another investment firm without performing any algorithmic trading activity is not algorithmic trading."
MiFID II provides that investment firms engaging in algorithmic trading and trading venues where such trading takes place are subject to enhanced regulatory scrutiny.
In particular, algo firms must abide by the Commission Delegated Regulation (EU) 2017/589 of 19 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the organisational requirements of investment firms engaged in algorithmic trading (OJ L 87, 31.3.2017, p. 417–448).
Regulated markets must have effective systems, procedures and arrangements, including requiring members or participants to carry out appropriate testing of algorithms and providing environments to facilitate such testing, to ensure that algorithmic trading systems cannot create or contribute to disorderly trading conditions on the market and to manage any disorderly trading conditions which arise from such algorithmic trading systems, including systems to limit the ratio of unexecuted orders to transactions that may be entered into the system by a member or participant, to be able to slow down the flow of orders if there is a risk of its system capacity being reached and to limit and enforce the minimum tick size that may be executed on the market (Article 48(6) of MiFID II).
Pursuant to Article 17(1) MiFID II, an investment firm that engages in algorithmic trading must, moreover, have in place:
- effective systems and risk controls suitable to the business it operates to ensure that its trading systems are resilient and have sufficient capacity, are subject to appropriate trading thresholds and limits and prevent the sending of erroneous orders or the systems otherwise functioning in a way that may create orcontribute to a disorderly market;
Specific requirements apply if an investment firm:
- engages in algorithmic trading to pursue a market making strategy (Article 17(3) and (4) of MiFID II,
- provides direct electronic access to a trading venue (Article 17(5)of MiFID II).
A subset of algorithmic trading is High Frequency Trading (HFT).
The term "automated trading" is also sometimes differentiated, it means the use of computer programmes to enter trading orders where the computer algorithm decides on aspects of execution of the order such as the timing, quantity and price of the order.
Regulated markets must identify, by means of flagging from members or participants, orders generated by algorithmic trading, the different algorithms used for the creation of orders and the relevant persons initiating those orders.
That information is available to competent authorities upon request (Article 48(8) of MiFID II).
Smart Order Routers (SORs)
Algorithmic trading encompasses smart order routers (SORs) where such devices use algorithms for optimisation of order execution processes that determine parameters of the order other than the venue or venues where the order should be submitted.
Automated Order Routers (AOR)
Algorithmic trading does not encompass automated order routers (AOR) where, although using algorithms, such devices only determine the trading venue or venues.
The inherent condition is that the order is submitted without changing any other parameter of the order (including modifying the size of the order by "slicing" it into "child" orders).
In case the same unmodified order is sent to several trading venues to ensure execution and it is executed in one of these venues, the functionality can also cancel the unexecuted orders in the other venues without qualifying as algorithmic trading.
An investment firm that engages in algorithmic trading in a EU Member State must notify this to the competent authorities of its home Member State and of the trading venue at which the investment firm engages in algorithmic trading as a member or participant of the trading venue.
The competent authority of the home Member State of the investment firm may require the investment firm to provide, on a regular or ad-hoc basis, a description of the nature of its algorithmic trading strategies, details of the trading parameters or limits to which the system is subject, the key compliance and risk controls that it has in place to ensure the conditions laid down above are satisfied and details of the testing of its systems.
The competent authority of the home Member State of the investment firm may, at any time, request further information from an investment firm about its algorithmic trading and the systems used for that trading.
The aforementioned information is communicated by the competent authority of the home EU Member State of the investment firm on the request of a competent authority of a trading venue at which the investment firm as a member or participant of the trading venue is engaged in algorithmic trading.
The investment firm must keep appropriate records and ensure that those records are sufficient to enable its competent authority to monitor compliance with the respective requirements.
|Last Updated on Tuesday, 13 February 2018 23:14|