The European Parliament passed legislation that will, for the first time in the E.U., impose regulation on high frequency algorithmic trading that relies on computer programs to determine the timing, prices or quantities of orders in fractions of a second. Any investment firm engaging in such trading will have to have effective systems and controls in place, such as circuit breakers to stop the trading process if price volatility gets too high. In addition, investment firms which provide direct electronic access to a trading venue will be required to have in place systems and risk controls to prevent trading that may contribute to a disorderly market or involve market abuse.
To minimize systemic risk, the algorithms used will have to be tested on venues and authorized by regulators. Moreover; records of all placed orders and cancellations of orders would have to be stored and made available to the competent authority upon request. The vehicle to accomplish these changes was legislation amending the Markets in Financial Instruments Directive (MiFID II).
Also for the first time, the legislation empowers authorities to limit the size of a net position which a person may hold in commodity derivatives, given their potential impact on food and energy prices. Under the new rules, positions in commodity derivatives traded on trading venues and over the counter would be limited, to support orderly pricing and prevent market distorting positions and market abuse. The European Securities and Markets Authority (ESMA) is authorized to determine the methodology for calculating these limits, to be applied by the competent authorities.
Position limits will apply to energy derivatives, such as those related to coal or oil, that are not currently regulated at the E.U. level, with transitional arrangements in place to ease the impact which will be reviewed by January 2018.
In order to avoid penalizing those who need to use commodity derivatives to manage non-financial businesses effectively, position limits would not apply to positions that are objectively measurable as reducing the risks directly related to the commercial activity.
MIFID II increases equity market transparency and for the first time establishes a principle of transparency for non-equity instruments such as bonds and derivatives. For equities a double volume cap mechanism limits the use of reference price waivers and negotiated price waivers (4% per venue cap and 8% global cap) together with a requirement for price improvement at the mid-point for the former.
Large-in-scale waivers and order management waivers remain the same as under MiFID I. As enacted, MiFID II also broadens the pre- and post-trade transparency regime to include non-equity instruments, although in view of the specificities of non-equity instruments, pre-trade transparency waivers are available for large orders, request for quote and voice trading. Post trade transparency is provided for all financial instruments with the possibility of deferred publication or volume masking as appropriate.
The measure also enhances the effective consolidation and disclosure of trading data through the obligation for trading venues to make pre- and post-trade data available on a reasonable commercial basis and through the establishment of a consolidated tape mechanism for post-trade data. These rules are accompanied by the establishment of approved reporting mechanism (ARM) and authorized publication arrangement (APA) for trade reporting and publication.