ESMA’s HFT rules widen net, cast shadow over dark pools

New rules designed to govern computerised trading in Europe will capture trading entities previously unregulated and could make dark pools much less attractive, according a provider of market surveillance tools.

Guidelines issued by the European Securities and Markets Authority (ESMA) in December have created a comprehensive regime for the operation of electronic systems by trading venues and direct market participants for the trading of all financial instruments defined under MiFID II.

But as well as high-frequency trading (HFT) firms and brokers that supply direct market access (DMA) or sponsored access, all other entities that deploy algorithmic trading strategies – either for clients or proprietary use – and access the market under their own membership, now fall under the new rules.

“This also includes smart order routers (SORs),” said Matthew Coupe, director of sales, EMEA, at Redkite, a market surveillance systems provider. “In fact, ESMA has made significant efforts to ensure all market member firms have been covered in this regulation, with the inclusion of the category of non-regulated firms trading on their own account.”

Coupe warned that as well as covering firms hitherto unregulated, new restrictions on certain types of electronic trading may lessen the practicality of dark pools as the guidelines could mean that a vast number of clients may unintentionally find themselves engaging in market abuse.

Ping orders – entering small orders to ascertain the level of hidden orders or to assess what is resting in a dark pool – could now potentially be classified as market abuse. Coupe said this could mean the strategy of sending an immediate or cancel (IOC) order to a mid-point book via an SOR could now also be classed as abusive and brokers will have to put in place a real-time surveillance system to monitor such activities.

“Firms trading through sponsored access will now be less hidden from the exchange and each sponsored access client must now be visible to the venues for the purposes of market surveillance,” he said.

However, Coupe noted internal broker crossing networks are not currently covered in the new guidelines. “This omission may provide a loophole venue for electronic flow from internal and external clients to go on unchecked,” he said.

Coupe also said while the new rules require greater transparency of algorithmic trading, certain limits to their reach remained.

“The broker executing a trade on behalf of a buy-side client doesn’t have the same obligations for their systems. There is no real-time transparency compliance, so the firm monitoring the system will not actually be responsible for the actual algo,” Coupe said.

The industry has concerns over the timeline for implementation. Published 22 December last year, ESMA’s rules need to be implemented by 1 May.

“This is an incredibly short window for participants to review and select a market surveillance solution and then implement and test it. However, it is possible,” said Coupe. “Even now, we’re finding that much of the market is still unaware of the new requirements and many firms may not even realise they are soon to fall under the regulation.”