Why new German HFT rules won't stop another Knight Capital

Author: | Published: 7 Aug 2012
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New rules proposed by the German government could slow down high frequency traders (HFTs) on the country’s regulated markets and multilateral trading facilities. But lawyers in Frankfurt have warned that closer HFT supervision may not prevent another Knight Capital.

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 trading activities.

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 & Sterling’s 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 were regulated.

The reforms will introduce a requirement for HFTs to apply for licensing as a financial services institution with Germany’s 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 implemented.

“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 Capital’s trading loss. But he questioned the efficacy of Germany’s 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 level.”

Tight deadline

According to Wieland, the move had the potential to irritate the market.

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 penalties.

What’s 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 said.

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,” he said.

How US markets were structured had a considerable impact on its vulnerability to trading glitches, he said. “Europe’s more fragmented trading venues make it much less vulnerable to the trading errors that spell disaster in US’s 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 said.

“Regulators worldwide must work to establish a regulatory framework that doesn’t put HFT firms out of business,” he said. “That would diminish liquidity on the market and ultimately make markets operate less efficiently.”

“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.