What you need to know before buying a German car

The latest draft of the German HFT ruling has some fairly serious implications for market participants and there is little time to prepare. The new law is expected to be finalised sometime in the middle of next year and the legislator expects the industry to comply within a three month grace period. Let’s look at some of the features added since the previous draft published in July.

Erstens: mandates that all algorithmically generated orders have to be flagged with a unique key when sent to a German exchange in order to allow the market surveillance system to allocate all orders to the generating algo.

Zweitens: mandates that any HFT-type business will be regulated.

Drittens: the two changes above apply not only to German firms or members of German exchanges, but also to any other trading firm that trades indirectly (e.g. DMA) on a German market.

The German legislator argues that this third point is necessary because otherwise German trading firms would be at a disadvantage compared to their non-German competitors. To my way of thinking, that’s a bit like being asked to abide by German traffic regulations just because I’ve bought a Volkswagen. But anyhow, I guess some non-German exchanges offering German stocks are applauding the new law. After all, it doesn’t apply to them – at least, not yet!

11 Responses to “What you need to know before buying a German car”
  1. Anonymous says:

    Do you have the exact definition of ‘HFT’ and ‘algorithmically generated orders’?

  2. C Furlong says:

    Hi Christian –
    These features look perfectly sensible to me and only a fraction of the impact compared to the latest EU approach to HFT. Identify your order as Algo driven and be regulated if you are going to be an highly active algorithmic market participant.
    I can only see these measures being introduced across all EU markets in time.
    I think the MTFs offering trading in pan-European instruments will be firmly in the regulators spotlight if they are not deemed to be promoting market stability.

  3. Christian Voigt says:

    To Anonymous
    To be precise, the current draft of Paragraph 16, Number 3 of the Boersengesetz states that algorithmic trading has to provide a flag to identify the originating trading algorithm. For the definition of algorithmic trading it refers to the draft of Paragraph 33, Section 1, Sentence 1a of the Wertpapierhandelsgesetz. Here algorithmic trading is defined as any trading where order parameters are generated by a computer algorithm and then send to one or more trading platforms. Excluded are trading systems that are used to forward or confirm orders. Thus, a very broad range of trading strategies will be affected.
    It goes without saying that all of this all my personal translation. Unfortunately, I’m not aware of any official English translation.

    To Colm
    Yes, I agree with you that it is much more sensible then slapping 500ms on every order. But in my views it still does not make it right. Algorithmic trading or high frequency trading are not strategies, they are technologies. If legislator believe enhanced regulation to protect price formation is necessary, then it should be addressed within MAD II or MAR and cover all trading strategies and not just pick on algorithmic orders. However, nobody seems to think that this new rule is necessary for manually generated orders. Thus, it shouldn’t be applied for algorithmic orders either.
    In regard to introducing that measure across Europe, there is a chance that this will happen. I just noticed that something similar slipped in via the latest presidency compromise for MiFID II. (http://register.consilium.europa.eu/pdf/en/12/st13/st13939.en12.pdf) In Article 51.6 in MIFID II it says “Member States shall require a regulated market to be able to identify, by means of flagging orders generated by algorithmic trading, the different algorithms used for the creation of orders and the relevant person initiating these orders.”

  4. Anonymous says:

    “Thus, a very broad range of trading strategies will be affected.”

    The vast majority of flow I would argue as this will capture all synthetic order types, even a simple synthetic Stop order or Iceberg. A similar regulatory development in India recently meant that some brokers decided it would be easier to simply flag ALL client FIX flow as ‘Algo flow’ as the use of SOTs and Algos in 3rd party and proprietary OMS/EMS platforms is so common.

    In this case it seems they expect the end algo to be identified, I assume with a unique ID? It will be interesting to see who will maintain unique registrations for thousands and thousands of strategies.

    Or perhaps this will result in non-member clients only being able to use broker provided platforms to enter orders?

  5. C Furlong says:

    I am not sure it matters which piece of legislation or regulation it comes in, I suppose it’s MAD if it is market abuse, MiFID if it is “non-abusive” HFT or market structure measures but being able to trace an order to an algo seems reasonable and smart. I think it is somewhat easier to trace a manual order to an operator.
    I take it the Germans don’t care what it comes in either as they are effectively “front running” these directives.

    I don’t see the benefit in allowing automated strategies to be run on the market when it is difficult or near impossible for a regulator or market authority to trace their behaviour and the responsible party in the event of any suspicion of damaging behaviour.

  6. Anonymous says:

    @ Colm – It would be interesting to hear your thoughts on the cost for administering this proposal that you support? Some other questions to consider: Who would be responsible for assigning a unique ID to each and every algo/synthetic order type/spreading tool? Would this ID need to be consistent across venues? If a DMA algo client is using two different brokers for the same algo do they register the same ID or two different ones? Who will ultimately wear the cost of this administrative burden?

  7. C Furlong says:

    Hello Anonymous

    Yes I do personally support the idea of order tracing to algo. I think the overall market benefits to all market participants of order tracking would outweigh the costs (in my personal opinion). In the same way that I think all pet dogs should be electronically chipped so that they can be traced back to their responsible owners, I also accept the fact that there are lots of dogs, several millions in the UK and lots of types of dogs, 200 plus breeds, some dangerous and some not so dangerous and they are not all bad but each dog owner should pay for their dog’s registration and that details are maintained by a registered utility. All details should be unique and consistent, regardless of what park the dog is running wild in.

    Incidentally it costs about £20-£30 to have a dog registered with a database utility in the UK and typically subsequent small charges if there are changes of details to the entry and there are a number of firms that run these facilities at a profit. Maybe the EU markets could work together on this, who knows.

  8. Anonymous says:

    I can understand holistically why you think this sounds like a good idea (as do the regulators) however if you think carefully about the practicalities then it quickly falls apart. I think this thread is a healthy case study. I think that your example about the registration of dogs is a vast over simplification. A dog is a unique physical entity and unique person/owner would register it. Simples. The concept of even defining a unique algo is difficult as is identifying the single person that owns / registers it and the way to legislate that. Let’s consider 3 key areas, all based off the current broad definition of an algo.
    1) Who registers the algo?
    2) How is that legislated?
    3) What exactly are you trying to achieve in terms of algo registration?
    Now let’s look at a couple of user cases:
    First let’s take a very simple example and assume that you have an online share trading account. Now you have quite a large portfolio and want to protect your downside so you enter stop loss orders to protect your investments. Ok you are using an algo now so you need to register that? Chances are you are not regulated so you couldn’t be made to? Or is it your online broker that should register it? If so then I guess you are talking about the member of the venue being responsible for algo registration? If so what benefit does that give anyone as the algo will be registered once but used by thousands of different individuals and probably on the same exchange ID. As such this won’t help the regulator or exchange to identify market abuse at all. You would HAVE to combine this with a flag that is passed through everyone’s systems (clients, brokers and exchanges) to identify each distinct user of each distinct algo. That’s a hell of a lot of work for everyone before we have even got to the burden of the cost (both in terms of resources and any fees) to register the algo. The net result of this would certainly be that to place that stop loss order to protect your investment will be a LOT more expensive for you, enough I am sure to make you think you will consider just wearing the risk. So you as the investor end up the loser here.

    Now taking that a little further let’s looks at an unregulated firm that is a non-member exchange trading via FIX through a broker (as indeed there are many). They are not regulated so again in order to enforce this either a) everyone who has electronic access to trade needs to be regulated or b) their broker needs to register on their behalf. If a) then that will end up with people exiting the market or if b) then as a broker the burden of trying to register every ‘distinct algo’ (in the same way you define a dog) is going to be impossible so I would most likely only allow them to trade via a screen (and I’ll have to remove any interfaces via DDE links to Excel first). Defining a distinct algo is a problem too so you will need to help me understand how you would propose to do that? If I offer a VWAP with an ‘aggressive’ or ‘passive’ option then is that one or two algos? It’s going to do something completely different depending on what you select. Then what about if they use a spread trader than can support up to 100 different legs with various options for making certain legs active, passive or leaning (reactive) and various options to protect you from being hung? How do you register that? Again the net result of all this is that end clients would have less choice in terms of execution offerings unless they become regulated themselves at great cost and take on the burden of registering their own algos and again we have the cost issue of everyone having to change their systems and all these costs will have to be pushed down the end of the line to the end consumer of the service.

    Now ALL firms and clients should have adequate records (retained for 5 years) where they document INTERNALLY their algos, systems and controls. They also should be retaining a full audit trail for 5 years so that if something did go wrong they can provide (on request by a regulator or exchange) an explanation of exactly what went wrong and who was responsible for what. They also should have processes in place for monitoring in real time for system issues and surveillance for market abuse. This should be sufficient and is a much more proportional approach to the algo registration and tagging issue.

    If you do still disagree then I would hope that you can at least articulate how you would propose that these problems could be overcome in a cost effective manner.

  9. C Furlong says:

    Hello Anonymous

    You are right, my example of registering a dog is an oversimplification and was used more as an analogy and I would not prescribe to use the same system for algorithms. That would be highly inappropriate and downright unusual.

    The point I am making is more about the fact that big registration systems can work and be beneficial and costs can be borne appropriately. I don’t think the tax payer would pick up the bill in this climate for this type of thing, so as you would expect that any cost due to increased regulation is nearly always picked up by the market participants – an outrage I know, but there is no other way.

    I am not sure we know the precise way in which regulators and legislators will implement and maybe they will not manage it, but for the purpose of interesting discussion I can consider your examples and I can play the regulator (devil’s advocate) to your frustrated algo provider.

    An online account might be expected to be provided by a member of a market, who would also provide the facility for entering stop orders, most do. You could reasonably, in the broadest definition of an algo, call this stop order mechanism an algo. If we are talking about “all algos everywhere” which is most regulators’ starting position, then it seems like a reasonable example. So who registers this stop mechanism? I think the broker providing the algo who is offering it for use on a market to his customers would sensibly be responsible for registering his stop order algo mechanism.

    If his customer misbehaves with an algo that you registered then I as a regulator or market authority will chase you the broker. I guess there is a limited amount of damage you can do to others with a stop order so I guess this is a good example of a good well-behaved doggy getting microchipped.

    I agree, as you say in this example, that it would not provide the ability to identify market abuse but it could identify the registered owner and author of a more abusive automated mechanism that resulted in an order or abusive activity under investigation.

    By the way, I wouldn’t rule out that the authorities may in the future insist on end user/customer IDs – particularly in this climate. We all know that there are examples of ID Markets in other regions. That would be some considerable change as any of this would be speaking hypothetically of course.

    If a buy side firm is using his own algos and he is going DMA, then as I understand Christian’s interpretation of the legislation is that the firm will then need to be regulated and therefore responsible for registering their algos. If this resulted in firms exiting the market I am not sure the regulators, politicians and legislators care too much. If you look at MiFID 1 and other regulations it was quite clear that the rules and activities promoted would hurt the smaller players and many would exit the market – this didn’t stop it becoming the reality, sad but true.

    I think as you say it can be difficult to precisely define distinct algos but the industry does generally manage it. At Fidessa we write algos for our customers and have algos in production. We don’t usually have a problem considering when we have a new algo on our hands or when it is really more or less the same as an existing one. I know most leading brokers who provide algos to their clients define a list of their available algos.

    We consider our regional variations of algos to be distinct algorithms, so US VWAP and Mexican VWAP are different algos using some identical blocks of logic but they are clearly different and adapted to market rules. I think your example of a VWAP aggressive vs a VWAP passive is a single automated mechanism with different parameters but I can think of items whereby algos can be argued to be distinct based on more extreme parameterisation. As for the spreader in your example, yes that needs registering too – I would suggest only once despite the varying number of legs and the different algo approach to those legs. Fidessa has one SOR technology in Europe where various execution strategies can be utilised through parameterisation – it is still only one mechanism with one general purpose so that would be a single registration in my book.

    I would suggest that considering the words and actions of the authorities of late that the existing record-keeping requirements are now being deemed to be insufficient to meet the needs of the modern market structure surveillance and regulatory oversight. I suppose if you are working for a well run firm you have adequate records and audit trails but not all firms have this in place. They also ALL should, as you say, have processes in place for monitoring in real time for system issues – clearly they don’t.

    I think one thing this registration suggestion certainly does is it allows us to make sense of the algo spaghetti that is out there on our markets. It forces firms to consider the profiling of their automated processes. It means that algos cannot be simply dropped onto the market and one would hope that it would encourage more diligence and testing in the algos and their mechanics. I don’t actually disagree with your position here or the complications raised by your examples of where this is hard, it is hard and complicated and expensive. But cost to the market is not the most important thing to the authorities anymore, it’s about stamping out abuse and systematic faults.

    But nonetheless, whether I agree with the principals behind the move or the stated or unstated aims, that is immaterial to the fact that it really might be coming. Maybe we should get together and draft the legislation.

  10. Anonymous says:

    In terms of trying to work constructively on something that provides value and could be practically implemented leveraging existing frameworks/technology the regulators would not go far wrong if they followed the example of the CME’s policies to flag automated trades as well as end user registration.
    They have leveraged standard FIX tags for both of these policies, 1028 for the Manual Trade (‘N’ if Algo) and 50 for the end user identification. These policies would seem to enable the venues to enhance their supervision and surveillance activity and to identify individual operators and so would be a proportionate way to meet the regulators broad objective and try to harmonise standards globally.

    More information on the policy can be found below:

    In terms of individual algo registration as I argued before I am unconvinced of what value this really adds and as we have discussed this is indeed very complex and costly. Any regulatory concerns with regards to testing algos, change control, systems and controls should apply to electronic trading in general and not just algos. If firms do not keep adequate records when they should then there is little sense in penalising the whole industry for this rather than the individual firms that might be in question.

    If the authorities ignore the cost to the market at the expense of all else then they may just be sowing the seeds for the next financial crisis as liquidity is priced out and of the financial system.

  11. C Furlong says:

    Interesting report on the matter from Shearman and Sterling http://bit.ly/RhM12i

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