Monday, November 14, 2011

Hedge Fund Industry Comments on ESMA Draft Guidelines on Electronic Trading

The hedge fund industry supports the European Securities and Market Authority’s principles-based approach in draft guidelines on systems and controls in a highly automated trading environment for trading platforms and investment firms. In a comment letter, the Managed Funds Association urged ESMA to include confidentiality safeguards and controls to protect trade information of clients that use direct market access and sponsored access as trading tools. The MFA disagreed with any regulatory mandate for imposing limits on order entry capacity.

The draft guidelines sit under the existing legal framework provided by the MiFID. The guidelines are engendered by the fact that trading in financial instruments has come to rely increasingly on the use of electronic trading systems, which have, in the main, replaced open outcry markets with screen-based markets. An important part of the innovation in this highly automated trading environment has been the rise of high frequency trading.

The MFA emphasized that ESMA’s regulatory guidelines, specifically those guidelines regarding market manipulation, should more consistently distinguish between technology and individual trading strategies. More specifically, the MFA emphasized that the use of technology should not be confused with high frequency trading or individual trading strategies. It is overly simplistic, said the MFA, to blame advancements in technology for any perceived deteriorations in market integrity and efficiency.

The MFA believes that high frequency trading technology, in itself, is not manipulative and in fact, brings numerous benefits to the financial markets. Indeed, there is strong evidence that high frequency trading increases market quality. At the same time, the MFA supports ESMA’s goal to eradicate illegal and improper trading from the markets. The way to review high frequency trading so that this balance is maintained, said the MFA, is to separate technology from strategy.
ESMA has proposed the imposition of limits per participant on order entry capacity.

While supporting the premise that regulated markets and multilateral trading facilities should have arrangements to prevent excessive flooding of the order book, the MFA strongly disagrees with any regulatory mandate for imposing limits on order entry capacity. Regulated markets and multilateral trading facilities should be permitted to make the choice, said the hedge fund association, based on competitive concerns, between building out their systems or imposing their own limits on order entry capacity.

ESMA did not propose guidelines for co-location, fee structures and tick sizes since they do not relate directly to the challenges for systems and controls of trading platforms and investment firms caused by a highly automated trading environment. There is also a limit to what ESMA could achieve through guidelines in these areas under the existing legislative framework.

More broadly, the MFA noted that execution techniques have enabled investors and traders to supply markets with liquidity and have in large part replaced market makers. The result has been to make trading more efficient and lower profit margins. The ESMA draft raises high frequency trading concerns with regard to market quality, abusive practices, and regulatory oversight. MFA believes that high frequency trading technology is, in itself, not manipulative and in fact brings numerous benefits to the financial markets.

The MFA urged ESMA in the final guidelines regarding high frequency trading to proceed cautiously out of concern for unintended consequences that could negatively impact investors by decreasing market liquidity, depth, and efficiency while raising transaction costs.