Esma’s automated trading rules seen as vague and rushed

Terry Flanagan

Some market participants believe that new guidelines for automated trading in Europe to prevent market abuse are too vague and may also have been rushed through too quickly.

The European Securities and Markets Authority (Esma) has written detailed reforms to better monitor algorithmic trading practices such as high-frequency trading and these guidelines became effective from the start of last month and are now being applied across the whole of the European Union.

The regulator, in only its second year in existence, wants to foster convergence in supervisory practices regarding automated trading across the 27-nation bloc and help in providing a level playing field to investors.

In December last year, Esma issued an initial set of guidelines around algorithmic and direct market access (DMA) electronic trading. The final requirements, Guideline 2012/122, were released in February and were implemented from May 1.

“Guideline 2012/122 is significant,” Magnus Almqvist, senior product specialist at SunGard’s capital markets business, a trading and technology firm, told Markets Media. “It covers both client and proprietary trading and would affect firms engaged in purely with proprietary trading as well as those offering DMA, who would now need to surveil and report on trading activities performed by their DMA clients.

“The timeframe gives regulators, market places and market participants only a few months to implement changes to pre-trade systems, order management systems, surveillance and monitoring systems, and internal organizations and processes—a very tall order.”

Almqvist believes that the guidelines, despite becoming active from May, will become fully enforced from about October across the EU.

“The Esma guidelines have a good coverage, despite being a bit vague, but it is up to the local competent authority to interpret them and translate them into what is suitable for their jurisdiction and the members that are trading in that area,” said Almqvist.

Esma lists four types of market abuse. The first category is that of ping orders, where you enter small orders in order to ascertain the level of hidden orders and is particularly used to assess what is resting on a dark platform. The second category of market manipulation is quote stuffing, whereby large numbers of orders and/or cancellations/updates to orders are entered so as to create uncertainty for other participants, slowing down their process and to camouflage their own strategy.

Thirdly, there is momentum ignition, which is the entry of orders or a series of orders intended to start or exacerbate a trend, and to encourage other participants to accelerate or extend the trend in order to create an opportunity to unwind/open a position at a favorable price. And finally, there is layering and spoofing, where a trader submits multiple orders often away from the touch on one side of the order book with the intention of executing a trade on the other side of the order book. Once that trade has taken place, the manipulative orders will be removed.

However, it’s the first category, that of ping orders, that has market participants slightly confused.

“Ping orders are an interesting one as it’s not necessarily an offense in itself; it’s just the way participants fishing for market direction can really affect other participants in the market,” Simon Appleton, director of regulatory consulting at Kinetic Partners, a regulatory consultancy, told Markets Media. “It’s a slightly strange one. I don’t look at that one and automatically think market abuse.”

Esma is also urging firms to monitor in real time their electronic trading systems.

“Real time isn’t clearly defined yet so some firms take the view that T+1 is close enough to real time, and for their purposes and how active they are in the markets that might be true in the short term,” said Almqvist at SunGard.

“The trend towards more efficient and more immediate surveillance is there and I am expecting firms to increasingly get into the seconds or minutes after the market event to analyze data and trigger alerts. That could be a large change for firms depending on what systems they have.”

Justin Amos, co-founder and chief operating officer of Redkite Financial Markets, a market surveillance provider, told Markets Media: “Certain quarters have pushed back on Esma. Some are more positive over Esma than others. But to be able to monitor the automated world you must do it in an automated fashion in real time, or in as real time as possible. We think Esma’s approach is the best way to find out what is going on.”

However, Almqvist at SunGard believes that firms could actually use Esma’s new automated guidelines, as well as new financial regulation such as the Dodd Frank Act in the U.S. and the Market Abuse Directive and updated Markets in Financial Instruments Directive in Europe, to their advantage.

“For a firm, these guidelines and forthcoming regulatory changes can be perceived as further obligations but, more than anything else, there are opportunities here,” he said. “I think that what you decide to do with your surveillance and compliance system can be a support to ensure that you stay ahead of the curve and actively participate in the legislative process that is ongoing right now. It can really help you to remain competitive in a market that is increasingly competitive.”

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