Algorithmic trading and high-frequency trading
Algorithmic trading, whereby orders are entered, modified and cancelled by computer, carries various risks. For example, a high number of order entries, modifications or cancellations within a very short space of time could overload trading systems. Algorithms may also react to market events and trigger additional algorithms as a result, which may in turn trigger even more algorithms (cascade effect), leading to an increase in volatility.
New notification requirement for entities engaged in algorithmic trading or offering direct electronic access (DEA)
From 3 January 2018, new notification requirements will apply to investment services enterprises as a result of the transposition of the Markets in Financial Instruments Directive II (MiFID II) through the Second Act Amending Financial Markets Regulations (Zweites Finanzmarktnovellierungsgesetz – 2nd FiMaNoG). These notification requirements will affect investment services enterprises that engage in algorithmic trading within the meaning of section 80 (2) sentence 1 of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG) (in the version valid from 3 January 2018) or that offer direct electronic access (DEA) to a trading venue pursuant to section 2 (30) of the WpHG (in the version valid from 3 January 2018). The notifications must be submitted to the authority responsible for supervising the investment services enterprise concerned. In addition, they must also be submitted to the authorities responsible for supervising the trading venues concerned.
Investment services enterprises are required to submit notifications to BaFin in the following cases:
The investment services enterprises are supervised by BaFin and offer DEA to a trading venue or engage in algorithmic trading. In this case, the notification requirement results from section 77 (2) sentence 1 and section 80 (2) sentence 5 of the WpHG (in the version valid from 3 January 2018).
The investment services enterprises are members or participants of a multilateral trading facility (MTF) or an organised trading facility (OTF) that is supervised by BaFin and offer DEA to this MTF or OTF or engage in algorithmic trading there. In such cases, the notification requirement to BaFin may also apply to companies that are not subject to supervision by BaFin. For these companies, the notification requirement may be derived from the provisions transposing the first subparagraph of Article 17(2) and the third subparagraph of Article 17(5) of MiFID II into the national laws of other EU member states.
BaFin has prepared a standard form which can be used by the investment services enterprises concerned to satisfy their notification requirements towards BaFin. The form must be sent by e-mail to the following email addresses:
Notifications regarding engagement in algorithmic trading: email@example.com
Notifications regarding offering DEA to a trading venue: firstname.lastname@example.org
BaFin is not responsible for the supervision of stock exchanges domiciled in Germany. Stock exchanges are supervised by the exchange supervisory offices of the Federal States. For this reason, investment services enterprises that engage in algorithmic trading as trading participants on a German stock exchange or that offer DEA to a German stock exchange must submit notification to the exchange supervisory office responsible for the respective stock exchange. The requirement to notify the exchange supervisory offices may also apply to companies that are required to submit notification under provisions that transpose the first subparagraph of Article 17(2) and the third subparagraph of Article 17(5) of MiFID II into the national laws of other member states.
It is anticipated that the stock exchanges domiciled in Germany will inform their trading participants of the procedures for submitting notifications to the exchange supervisory offices in a corresponding circular.
Further information regarding procedures for notifying exchange supervisory offices can be found using the links listed below. Questions concerning procedures for notifying these authorities can be sent to the email addresses given.
Exchange supervisory offices:
Exchange Supervisory Office of Baden-Württemberg: Ministry of Economic Affairs, Labour and Housing of Baden-Württemberg (Ministerium für Wirtschaft, Arbeit und Wohnungsbau Baden-Württemberg)
Exchange Supervisory Office of Bavaria: Bavarian Ministry of Economic Affairs and Media, Energy and Technology (Bayerisches Staatsministerium für Wirtschaft und Medien, Energie und Technologie) (e-mail: algoanzeige @ stmwi.bayern.de and deaanzeige @ stmwi.bayern.de)
Exchange Supervisory Office of Berlin: Senate Department for Economics, Energy and Public Enterprises (Senatsverwaltung für Wirtschaft, Energie und Betriebe)
Exchange Supervisory Office of Hamburg: Ministry of Economic Affairs, Transport and Innovation (Behörde für Wirtschaft, Verkehr und Innovation)
Exchange Supervisory Office of Hesse: Ministry of Economics, Energy, Transport and Regional Development (Hessisches Ministerium für Wirtschaft, Energie, Verkehr und Landesentwicklung) (https://service.hessen.de/html/9496.htm)
Exchange Supervisory Office of Lower Saxony: Ministry of Economic Affairs, Labour and Transport of Lower Saxony (Niedersächsisches Ministerium für Wirtschaft, Arbeit und Verkehr)
Exchange Supervisory Office of North Rhine-Westphalia: Ministry of Finance of the Federal State of North Rhine-Westphalia (Ministerium der Finanzen des Landes Nordrhein-Westfalen) (e-mail: V-BoersenaufsichtNRW @ fm.nrw.de)
Exchange Supervisory Office of Saxony: Saxon State Ministry of Economic Affairs, Labour and Transport (Sächsisches Staatsministerium für Wirtschaft, Arbeit und Verkehr)
In order to counter the risks adherent to algorithmic trading and high-frequency trading, the legislature enacted the Act on the Prevention of Risks and Abuse in High-frequency Trading, or High-frequency Trading Act (Hochfrequenzhandelsgesetz). The Act entered into force on 15 May 2013 and contains provisions relating to high-frequency and algorithmic trading which apply to both trading participants and trading venues. It is based on the new European provisions on algorithmic and high-frequency trading, which are envisaged as part of the overhaul of the Markets in Financial Instruments Directive (MiFID).
High-frequency trading is a form of algorithmic trading and often involves a large number of order entries, modifications or cancellations within microseconds. High-frequency traders seek to be as near as possible to a trading venue's server in order to derive speed advantages from the short distance the signals need to travel.
The following describes the main provisions of the High-frequency Trading Act (Hochfrequenzhandelsgesetz):
Authorisation requirement for high-frequency traders
High-frequency trading is subject to an authorisation requirement according to the German Banking Act (Kreditwesengesetz – KWG). The authorisation requirement applies to all direct and indirect trading participants in organised markets or in multilateral trading facilities (MTF) in Germany who trade using high-frequency algorithmic trading techniques, where no service to third parties is rendered. High-frequency algorithmic trading techniques are characterised by:
- the use of infrastructure intended to minimise latency (e.g. co-location, proximity hosting);
- system determination of order initiation, generation, routing or execution without human intervention for individual transactions or orders; and
- a large volume of messages throughout the day.
The authorisation requirement triggers other obligations such as requirements relating to risk management and capital adequacy as well as obligations to report to BaFin.
System and risk controls
Investment services enterprises engaging in algorithmic trading must have adequate system and risk controls in place for their trading systems (section 33 (1a) of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG). They must also have effective business continuity arrangements for handling unforeseen disruptions to their trading systems. Furthermore, they must ensure that any modifications to computer algorithms used in trading are documented appropriately. The requirement to maintain system and risk controls also applies to asset management companies and self-managed investment stock corporations.
Trading participants must designate orders generated through algorithmic trading and in doing so indicate the algorithm used (section 16 (2) no. 3 of the German Stock Exchange Act (Börsengesetz – BörsG). Exchange rules, which are subject to the approval of the exchange supervisory authorities of the federal states, contain specific provisions on identifying algorithm-based orders.
The Hessian Ministry of Economy, Transport and Regional Development (Hessisches Ministerium für Wirtschaft, Verkehr und Landesentwicklung), which acts as the exchange supervisory authority for the Frankfurt Stock Exchange, has published information on identifying trading algorithms.
Appropriate order-to-trade ratio
In addition to the above, trading participants must ensure an appropriate order-to-trade ratio in order to prevent risks to the proper functioning of exchange trading operations (section 26a of the BörsG). The various exchange rules contain specific provisions in this regard. Eurex has published circulars on the implementation of order-to-trade ratios.
Apart from the provisions referred to above, the Act imposes additional obligations on trading venues to charge separate fees for excessive use of exchange systems, to determine appropriate minimum tick sizes and activate circuit breakers to reduce volatility. The Act also clarifies that trading techniques involving computer algorithms may, under certain circumstances, also constitute market manipulation. Finally, the Act gives supervisory authorities powers to request information regarding algorithmic trading.