Germany is taking the lead in Europe by imposing stricter regulation on algorithmic trading but many futures firms are still ignorant of this, fuelling concerns over performance and trading volumes, writes Joe Parsons.

Under the German High Frequency Trading (HFT) law firms will be required on April 1 to uniquely identify each algorithmic order sent to a German exchange with a key/flag, detailing in real time the entire decision process behind that order.

Firms will also have to ensure all orders must reference the history of the decision making process behind that order and any other algo that was involved.

Regulators and exchanges have argued that algo trading has made surveillance of the markets more difficult and abusive behaviour harder to spot, and algo flagging is one way in which Eurex, Germany’s derivatives exchange, and BaFin, Germany’s financial regulator, aims to deal with this issue.

However, the industry is concerned over the negative implications this could have on firms, which will have to make dramatic changes to their algos to ensure that they are able to provide the necessary data to the regulators.

"Hampering performance"

There is the possibility it will impact on firms performance, as to report the entire decision path of an algo order in real time is a complex requirement.

“If market participants are forced to focus on correctly tagging their algorithmic decision processes, rather than collaborating their algorithms to respond more adeptly to changing market circumstances, it may hamper their performance,” said PJ Di Giammarino, founder and CEO of JWG Group, a regulatory think tank.

The sheer diversity of some algorithms will present a huge task for firms to report all the necessary data related to that algo.

“It is a complex and complicated requirement to deal with because there can be many inputs that can go into algorithmic decisions – particularly when it comes to market-making and statistical arbitrage strategies,” added Di Giammarino.

"Firms that were not ‘high frequency traders’ under the German HFT law will not have realised they are required to flag their algos," said Sam Tyfield, Vedder Price.

In addition, according to Rob Boardman, CEO of ITG, a broker: “Firms have had to divert resources to ensure they come under the algo flagging requirements.”

Unaware of scope of regulation

There is also a large amount of uncertainty amongst some futures traders, many of which are unaware of their obligations to flag their algorithmic trading activity.

“A lot of firms that were not ‘high frequency traders’ under the German HFT law will not have realised they are required to flag their algos, when in reality, all firms who use algos are required to flag under the law,” said Sam Tyfield, a partner at law firm Vedder Price.

Many futures traders believe that because they are not defined as a high frequency trader, they are exempt from the flagging requirements, and this shows many are still unaware over the scope of the requirements.

Tyfield also argued there are certain practical issues on how firms will have to make their flags unique.

“If a NCM (non-clearing member) uses a GCM (general clearing member) for execution through the GCM’s FIX gateway, since neither can control how the other flags its algos, it is possible the flag used by the NCM could conflict with a separate flag used by the GCM,” added Tyfield.

“The regulator is going to insist on unique algo flags but the industry is going to need to find solutions for this (and other) practical issues.”

Determining "new trading behaviour"

Whether trading firms direct orders away from such markets to other jurisdictions remains to be seen, but it’s a certain possibility,” said Christian Voigt, Fidessa.

Firms will have to apply flags for the lifetime of an algo which cannot be altered unless the algo changes in such a way that constitutes ‘new trading behaviour’. The issue here is that firms will have to continually determine this.

“Market participants are faced with the very difficult prospect of balancing innovation with compliance. As they evolve their algos to better provide liquidity ... they must continually determine if they’re creating ‘new trading behaviour’,” said Andrew Lisy, algo product manager at OptionsCity.

Furthermore, the issue of determining ‘new trading behaviour’ could also affect the regulators' ability in overseeing high frequency and algorithmic trading. 

“Regulators are going to have a very difficult time drawing a line as far as determining what constitutes ‘new trading behaviour,’ as even seemingly minor changes in the parameter inputs to certain algorithms can dramatically alter how that algo places orders in the market,” added Lisy.

Finally, algo flagging requirements could potentially hurt trading volumes, as traders could look to other derivative exchanges in the search for innovation and to evolve their algos.

“The requirement to flag algos currently only covers exchanges regulated in Germany. Whether trading firms direct orders away from such markets to other jurisdictions remains to be seen, but it’s a certain possibility,” said Christian Voigt, product management, Fidessa.

Despite these issues, algo flagging is set to come into force on April 1, and Germany’s derivatives and securities exchanges are making sure its members are prepared for the requirements.

Eurex issued guidance to its members in January detailing the provisions of algo flagging, and has created a new field in its trading systems for members to use in identifying their firms.

Deutsche Boerse said in a statement: “We are working with our members to ensure that they are fully compliant with the new flagging requirements.”