Back to school for MiFID II

The review of MiFID/MiFIR is now well underway following the regulations’ 2-year anniversary in 2020. In their most recent consultation paper ESMA, the European securities and markets authority, was keen to hear from trading venues and investment firms engaged in algorithmic and high-frequency trading. Consulting on the efficiencies of the existing rules framework, ESMA is looking closely at the impact of the requirements set out in the 2018 MiFID II. A report on the findings is expected in July.

In the consultation paper, ESMA discusses the organizational requirements for firms engaged in algo trading, and the requirements for trading venues that enable these activities on their systems. Much in the spotlight is our old friend RTS 6, the regulatory technical standards for algo trading firms. RTS 6 is a kingpin of MiFID II. It covers general organizational requirements, obligations around governance and accountability, pre-trade risk checks, algo deployment, system monitoring, and much more besides. This time around ESMA focuses on the testing of trading algorithms.

Currently, the algo regulations include 3 types of testing:

• Venue conformance testing.
• Annual stress testing.
• Functional or behavioural testing for new or amended algos.

On the first two, ESMA seems happy that the framework is operating well, and no changes are proposed. However, behavioural tests come under some scrutiny, both for firms and venues.

One aspect that ESMA picks up on is firms’ obligation to test that their algorithms continue to function under “disorderly trading conditions.” In the run up to MiFID, the industry debated long and hard about what that might mean and arrived at their own conclusion. ESMA is now considering clarifying the definition – cue a further and longer debate! ESMA believes that a clear definition of disorderly trading conditions would help to improve testing and testing environments. Undoubtedly, a clarification would be welcome. But 2 years into MiFID, this could in turn lead to more questions from participants. And that would mean the publication of regulator Q&As to qualify interpretation and industry guidance papers extolling the virtues of possible improvements to testing regimes. A seemingly small clarification might necessitate significant adjustments, which would impact all firms and venues alike.

There is a big focus in the consultation on what algo testing gets done, what environments are used, and evidencing thereof. For venues, this concerns their due diligence around their systems and controls for members’ algo trading and the test environments they provide. As venues adapt to meet any new obligations in the future, their member algo certification processes could become more onerous.

ESMA also revisits the annual self-assessment for investment firms. While stress testing looks set to remain an annual requirement, the overall self-assessment could be made two-yearly to offset its greater difficulty. A standard format and requirements to submit to the local regulator are also discussed.

So, it really is back to MiFID school for some. It sounds as though some reworking of MiFID II solutions could be on the timetable for the coming term. How the processes for regulatory review could pan out for the UK in view of Brexit, remains to be seen. Watch this space …