Brexit

Ensuring traders
pass the test of
MiFID II and MAR
By Eddie Thorn, Director
of Capital Markets, SQS
sanctions of up to four-year imprisonment under
CSMAD (or its UK equivalent). Whilst MAR does not
mandate non-live testing of algorithms, many
of the abusive behaviours described in MAR can
be detected by implementation of new testing
methodologies which will prevent a trading firm
falling foul of MAR and its onerous penalties.
A Knight’s tale
These may be extremes of the events that MiFID
II regulation is seeking to stop being replicated
on European exchanges, but lesser events occur
with unnerving regularity. It is worth noting that it
is not necessarily a major market crash that is the
only concern, as much as the need for markets to
operate fairly and orderly on a day-to-day basis.
Under MiFID II, investment firms will now be
required to test and ensure the stability of their
algorithms under stressed market conditions
to prevent such disorderly markets and flash
crashes as outlined above. Yet, investment firms
and exchanges have found it difficult to correctly
replicate these real markets in a nonlive
environment, where the algorithm being
tested interacts realistically with other relevant
market players.
A change in
the legislation
landscape
With recent changes to the Markets in Financial
Instruments Directive (MiFID II), tighter regulations
are on the horizon. All firms using any form of
trading algorithm need to invest in a new way
of testing their algorithms or face ceasing
trading as MiFID II places stringent algorithm
testing requirements on both buy and sell side
investment firms. Ultimately, it’s the senior
management who will carry explicit responsibility
for compliance. Although there is time for change
– it needs to happen now for the compliance
deadline to be met.
The change has been born out of the regulator
becoming increasingly fearful that trading has the
potential to cause rapid and significant market
distortion. Additionally, hefty financial penalties
could be enforced from July 2016 under the Market
Abuse Regulation (MAR). This could be up to €5
million on individuals and €15 million, or 15 per
cent of turnover, on firms where algorithms cause
market disorder or commit market manipulation.
Senior managers could even be facing criminal
The Knight Capital meltdown in 2012 is a sobering
example of the ramifications of an out-of-control
algorithm 1 . It was widely reported at the time
that Knight Capital deployed an insufficiently
tested algorithm to the production environment
with an obsolete function. When released into
production, defective code within the algorithm
caused a major disruption in the prices of some
148 companies listed at the New York Stock
Exchange. This resulted in four million executions
in 154 stocks for more than 397 million shares
in approximately 45 minutes. This proved to be
a costly 45 minutes for Knight Capital, with an
estimated pre-tax loss of some $440 million which
led to its ultimate collapse, caused as a result of
the single faulty algorithm.
Faulty algorithms are also behind some of the most
recent flash crashes. As recent as October 2014,
there was one such example in the US Treasury
Markets. On the day in question, there was a rapid
surge in bond prices across cash and futures
markets followed by a similarly rapid retracement
in a twelve-minute window lasting from 9:33 to
9:45 ET. Although the size of the move was not
unprecedented, it was highly disproportionate
to changes in exogenous information. Whilst not
implicitly called out, it is widely thought that such
unusual movements were due to a faulty algorithm
that could have been discovered if more rigorous
testing was in place.
This was just a few years after probably the most
famous flash crash of all, where in May 2010 stock
market trader Navinder Singh Sarao was deemed
“significantly responsible” for a flash crash of the
US equity and index futures indices. The crash was
thought to be caused in part by his sophisticated
‘spoofing’ algorithm.
Requirement
for a new test
methodology
Trading venues will require members to “certify
that the algorithms they deploy have been tested
to avoid creating or contributing to disorderly
trading conditions” (RTS 7, Article 10, 1) 2 . Such
tests and certification must be made both prior
to initial deployment of algorithms and on any
“substantial” update. Additionally, as part of an
annual assessment, the investment firms must
retest their algorithms to “ensure that they are
capable of withstanding increased order flows or
market stresses” (RTS 6, Article 10).
The purpose of testing for disorderly trading
conditions is to “recreate real market conditions
to ensure the well-functioning of algorithms
under changing circumstances” (3.2.33) and must
include tests that show that the algorithm “can
continue to work effectively in stressed market
conditions” (3.1.16).
Notably, the “responsible party designated by
senior management of the investment firm shall
sign off the initial deployment or substantial
1. https://en.
wikipedia.org/wiki/
Knight_Capital_
Group#2012_stock_
trading_disruption
2. https://www.
esma.europa.eu/
sites/default/files/
library/2015/11/
2015-esma-1464_
annex_i_-_draft_
rts_and_its_on_
mifid_ii_and_mifir.pdf
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