The Problem With Enforcing Regulations
ECB Governing Council member Nowotny wants a ban on high frequency trading. According to MNI , Nowotny said: “One case in point is high-frequency trading, which evidentially does not have any added macroeconomic value… there is nothing to regulate there; it simply has to be forbidden.” Nowotny also said “As long as you are trying to regulate something, you give people the possibility to circumvent it, and they will find a way to do so.”
This exact point was recently discussed in a paper titled “Market Making Obligations and Algorithmic Trading Systems” written by Prof. Dave Cliff of the University of Bristol. The paper is a detailed analysis of MiFID2 Article 17(3) and why this regulation would be almost impossible to enforce. Clause 17(3) is known as the “market maker obligation” clause. We have long advocated that market makers who enjoy the benefits of today’s high speed markets should be subject to some form of obligations. But after reading Prof. Cliff’s paper, we find it hard to imagine that regulators would be able to draft up the appropriate requirements for market makers. And even if they did set some form of obligation, automated market makers would just figure out a way to get around the rules. Apparently, Mr. Nowotny agrees.
MiFID2 was proposed in October 2011 and aims to improve on regulations known as MiFID that were established in October 2007 by the European Commission. The paper by Prof. Cliff focused in on just one section of the proposed rules, section 17 (3). This section originally stated:
“17(3) An algorithmic trading strategy shall be in continuous operation during the trading hours of the trading venue to which it sends orders or through the systems of which it executes transactions. The trading parameters or limits of an algorithmic trading strategy shall ensure that the strategy posts firm quotes at competitive prices with the result of providing liquidity on a regular and ongoing basis to these trading venues at all times, regardless of prevailing market conditions.”
Prof Cliff dissects this proposed regulation in his paper and basically says that even if approved, this regulation could easily be gamed and is not enforceable. Prof Cliff says:
“The danger then is that, in fulfilling the desire to be seen to be doing something, regulations are drafted that are tokenistic, difficult to interpret coherently, and largely ineffective in practice because of the ease with which they can be avoided.”
Referring specifically to 17(3), Prof Cliff says:
“It suffers from key words and concepts being used without any care having been taken in defining those words or concepts, and from failing to consider how those words and concepts relate back to actual industry practice.”
The European Parliament apparently agreed with Prof. Cliff and earlier this year offered some amendments to MiFID2. Section 17(3) was narrowed to apply to only HFT market makers and now reads:
“17(3) Where an investment firm engages in a high-frequency trading strategy which meets the conditions of Article 4(30b)(vi) that strategy shall be in continuous operation during the trading hours of the trading venue to which it sends orders or through the systems of which it executes transactions. The trading parameters or limits of such a high-frequency trading strategy shall ensure that the strategy posts firm quotes at competitive prices with the result of providing liquidity on a regular and ongoing basis to these trading venues at all times, regardless of prevailing market conditions.”
Unfortunately, even after the change in wording, Prof. Cliff still feels that that the definition will be gamed. He says: “Nevertheless, the current phrasing of the regulations is such that programming self-monitoring HFT strategies that can avoid the regulation is relatively straightforward, and hence this clause in Article 17 is unlikely to have the desired effect.”
European regulators are far ahead of their US counterparts when it comes to attempting to regulate the new high speed markets. But as we can see from this paper, implementing new regulations is not that easy. And designing regulations and trying to predict their unintended consequences is nearly impossible. This is why we are not advocating a full scale regulatory overhaul of what we consider to be a broken market. We think that the quickest solution to our market structure woes is a market based solution. But our regulators could ease the path for this market based solution by eliminating a few unfair practices that currently exist in the market. As we have said before, regulators could eliminate the maker taker model which would be a good first step in allowing for a market based solution to develop.