New rules proposed by the German government could slow down
high frequency traders (HFTs) on the countrys regulated
markets and multilateral trading facilities. But lawyers in
Frankfurt have warned that closer HFT supervision may not
On July 30, the German Ministry of Finance published a draft
Act for the Prevention of Risks and the Abuse of High Frequency
Trading. The legislation pre-empts the proposed reform of
the Markets in Financial Instruments Directive (
Mifid II), which will introduce a licensing requirement for
HFT firms and a specific regulatory framework for algorithmic
The reforms address many of the regulatory methods and
approaches outlined and addressed in the
Iosco Consultation Report of July 2011 and envisaged under
Mifid II. They aim to better establish systemic stability in a
sector that has to-date operated with little supervision.
Shearman & Sterlings Dr. Andreas Wieland told
IFLR the suggested changes could have enormous
consequences for the German market as some HFT firms struggle
to comply. But he stressed market vulnerability to algorithmic
errors, such as that experienced in the
May 2010 flash crash and last week by Knight Capital, was
exacerbated by its specific structure and not just how HFTs
The reforms will introduce a requirement for HFTs to apply
for licensing as a financial services institution with
Germanys financial regulator BaFin [Bundesanstalt
fu¨r Finanzdienstleistungsaufsicht]. Proposed
amendments to the German Banking Act and the German Securities
Trading Act will also enhance the powers of regulatory
authorities, in particular requiring HFTs to submit their
algorithmic trades and strategies to the regulator.
They avoid the more controversial elements discussed in
connection with Mifid II, such as the requirement for a formal
market-making obligation and a minimum lifetime for orders.
Both would have the potential to destroy the business models of
many HFT firms and would likely have severe consequences on
liquidity and market efficiency at German trading venues, if
The reforms force firms engaged in algorithmic trading
to implement adequate and sophisticated risk management
strategies and to ensure the trading system has sufficient
capacity and effective safeguards to prevent erroneous
orders, Wieland said.
The newly introduced maximum order to trade ratios,
could have the effect that certain trading strategies cannot be
deployed with the same leverage or volume as currently used,
thereby curtailing the activities of HFT firms on German
venues, he added.
Wieland said enhanced focus on HFT firms risk
management process was undoubtedly a key tool to prevent a
repeat of events like Knight Capitals trading loss. But
he questioned the efficacy of Germanys approach.
It is as much surprising as questionable that Germany
has decided not to wait for a common European solution given
that the Mifid II proposals are already at a fairly advanced
stage, he said. Instead, Germany appears to opt
not for the first time for a national solution
that precedes and pre-empts legislation at an EU
According to Wieland, the move had the potential to irritate
With an August 17 deadline for comments on the new draft
legislation, there is little room left for the industry and
market participants to influence matters further. This
will create substantial challenges for trading venues,
investment firms and their trading and compliance
departments, said Wieland.
Interested parties will need to swiftly analyse the impact
of the draft legislation on their business models and practices
and decide whether and how these can be brought in compliance
with the new legislation and to lobby for any necessary
and/or desirable revisions.
Training of personnel, surveillance and strengthening a
culture of compliance will also be crucial to avoid trading
practices that may subsequently be perceived as market
manipulation, and consequential investigations, fines and
Whats more, if the new legislation is adopted as it
stands, HFT firms that wish to continue trading on German
trading venues will need to quickly prepare for a license in
Germany or may have to cease trading at German trading venues.
It may be worth examining alternative solutions such as
whether Mifid license could be obtained in another EU
jurisdiction with a passport into Germany, he said.
Some HFT firms could avoid the need for getting
licensed in Germany and retreat from the German market,
he said. There is a risk that this could result in less
liquidity on German trading platforms.
Institutions engaged in algorithmic trading should closely
monitor the development and impact of the proposed legislation.
It may well be that the proposed legislation will be
subject to changes and clarifications during the parliamentary
procedure, he said.
Whatever the outcome, these suggested changes make
clear that the time for HFT firms, be they US or European, to
operate below the radar of regulators is over, he
Nonetheless, people should be aware that even with the best
regulation and risk management systems in place, mistakes do
happen. The German approach may help regulators better
supervise HFT firms, but that does not entirely rule out
singular events like Knight Capital from happening again,
How US markets were structured had a considerable impact on
its vulnerability to trading glitches, he said.
Europes more fragmented trading venues make it much
less vulnerable to the trading errors that spell disaster in
USs highly interconnected markets, he said.
However, the Securities & Exchange Commission has
recently backed an initiative to introduce greater certainty
into the US market by
limiting the number of cancelled trades.
The US trade-through rule fostered inter-linkages between US
trading venues, having the consequence that whenever there was
an erroneous series of trades caused by rogue algorithms this
could affect the entire market. This structure contributed to
the May 2010 flash crash, he said.
Even so he believed the benefits of HFT were enormous.
It adds significant liquidity to the market, he
Regulators worldwide must work to establish a
regulatory framework that doesnt put HFT firms out of
business, he said. That would diminish liquidity on
the market and ultimately make markets operate less
A regulatory balance needs to be struck which
stabilises the market by introducing effective risk management
procedures, and emphasises the need for proper business
continuity plans and algorithmic trading stress testing without
killing the industry, Wieland said.