EU proposals to regulate high frequency trading under MiFID may well end up raising transaction costs for end-investors and pushing trading into the dark rather than making markets more transparent, argues Remco Lenterman.
Remco Lenterman is chairman of the FIA European Principal Traders Association.
"The negotiations on the revision of the EU’s law for securities markets, the Markets in Financial Instruments Directive (MiFID), are entering a crucial phase. Some proposals may well end up raising transaction costs for end-investors and pushing trading into the dark rather than making markets more transparent.
My particular concern is the proposed obligation for ‘algorithmic market making strategies’ to quote continuously under any market condition. This is one of the most controversial articles in the review. It is also the one whose objective remains elusive. However, its effects are clear: market making under these conditions will be almost impossible. This is despite the fact that even the most skeptical authorities acknowledge the importance of electronic market makers on exchanges. For example, they are exempted from France’s new financial transaction tax.
It seems to be lost on advocates of the continuous quoting rule that it is unprecedented. We are aware of no legislation anywhere that requires a group of market participants to continuously bear risk, without regard to proper risk management. In other words, if your market and operational risk systems tell you that it is prudent to withdraw a quote from the markets, this law would prohibit it, in direct contradiction with another article in MiFID regarding the need for risk controls. Forcing a group of participants to continuously bear risk in these markets is akin to forcing banks to lend money to anyone who walks into their branches regardless of credit history. Oh, and when one of their branches fails to open one day because of a flooding problem, they are in contravention of the law
If that were not enough, other proposals in MiFID would also severely restrict the job of an electronic market maker. To explain this, it is helpful to give a short history of exchange traded markets. When the option markets first started to move from the floor to electronic trading, electronic market makers used to enter bids and offers manually. This was relatively easy because spreads (the difference between the bid and the ask price) were high in those days and once entered, these orders needed updating just a few times a day as option prices moved up and down. When markets became more competitive, and technology more advanced, market makers started to use algorithms to update prices. This meant that spreads narrowed, benefiting end users, who ultimately pay the difference between the bid and the offer.
Naturally, the narrower the spread, the more price updates a market maker needs to send and as a result the number of unexecuted orders goes up. Exchanges have accommodated this increase in speed and data traffic because of the causal positive link between speed and capacity, and narrow spreads and added liquidity, which is precisely what they strive for. As a result, the ratio of unexecuted orders over executed orders (the order to trade ratio) in some exchange traded derivative markets is very high, sometimes in the thousands. That is not because these market makers do not want these orders to execute. Rather, that there is a lack of willing buyers and sellers at that precise moment.
For whatever reason, critics have decided there is something unholy about the number of unexecuted orders and wish to put a firm limit on them. Some groups even argue for a cap of four to one. In addition, they believe that orders should be valid for a minimum amount of time, such as half a second. There would also be an extra charge for unexecuted orders to serve as an extra disincentive.
Think about it. Electronic market makers would be forced to quote continuously, they would be unable to update or withdraw their prices when their risk parameters told them to, there would be limits on the number of price updates altogether and they would need to pay extra for these same updates. It doesn’t take a rocket scientist to figure out that the only way to respond would be to significantly widen these quotes in equities and exchange traded derivatives such as options and ETFs. Equally, the barriers to entry into electronic market making would be much higher because many participants would simply be unable to quote continuously.
Ironically, such an outcome would be a boon to many participants in the financial industry for the simple reason that wider spreads will cause more over the counter trading. This is generally more profitable than on-exchange trading – and is therefore more expensive for end users. This surely cannot be the objective of those pushing for these regulations."