The German Federal Parliament adopted a bill on February 28, 2013, setting forth detailed rules and provisions dealing with so-called “high frequency trading” (the “HFT Rules”). Rather than being enacted on a stand-alone basis, the HFT Rules will be integrated into, and amend, existing statutes, such as the German Securities Trading Act (Wertpapierhandelsgesetz – “WpHG”), the German Banking Act (Kreditwesengesetz – “KWG”), and the German Stock Exchange Act (Börsengesetz – “BörsG”) and will supplement existing provisions regulating (i) trading with financial instruments (WpHG), (ii) the operation and functioning of stock exchanges and other trading venues (BörsG and WpHG), and (iii) the provision of services related to the trading in financial instruments (KWG and WpHG). The HFT Rules came into force on May 14, 2013.
Newly Introduced Obligations and Requirements
Licensing and Capital Requirements
Prior to the HFT Rules coming into force, an entity engaged in trading with financial instruments in Germany was required to obtain a license from the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – “BaFin”) only if it either (i) provided financial services (Finanzdienstleistungen) to third parties or (ii) conducted other types of banking business (Bankgeschäfte) as defined in the KWG. The effect of this was that trading with financial instruments on one’s own account did not trigger any licensing or registration obligations unless the activity was carried on for the purpose of acting as a market maker, which is considered to be the provision of a financial service.
The HFT Rules change this – dealing on one’s own account is now considered a financial service (and thus triggers licensing requirements, subject to the transitional period described below) if it is done using so-called “high frequency algorithmic trading techniques”, which are characterized by (i) the exploitation of infrastructures intended to minimize latency, (ii) a system automatically “deciding” whether orders are submitted, generated, transmitted or executed without the necessity of human intervention for individual trades or orders, and (iii) a high intraday number of orders, quotes or cancellations.
Once the transitional period expires, therefore, entities purchasing or selling financial instruments on their own account on a German stock exchange or multilateral trading facility by means of a high frequency algorithmic trading technique will be required to hold a license that covers “dealing on own account” within the meaning of Section A (3) of Annex I to the Directive 2004/39/EC on markets in financial instruments (“MiFID”) and will need to comply with stringent substantive requirements, such as (i) a minimum initial funds condition (which requires own funds of at least €730,000 if the entity applies for the license from BaFin, or the amount required under relevant home Member State law for an entity applying to another EEA regulator but making use of the passport regime), (ii) the requirement that the persons who effectively direct the entity’s business are of sufficiently good repute and sufficiently experienced so as to ensure the sound and prudent management, and (iii) the requirement that shareholders with qualifying holdings do not compromise the entity’s sound and prudent management.
It is worth noting that the licensing requirement is not limited to members of a German stock exchange (or multilateral trading facility). Entities that are granted direct electronic access to the stock exchange by a member of such stock exchange – for example, via order routing systems – will also be obliged to obtain a license if they employ high frequency algorithmic trading techniques. This applies in particular to customers of stock exchange members that are permitted by that member directly to enter orders into a stock exchange’s trade matching system for execution.
Because the requirement to obtain a special license is only triggered if the relevant entity trades on its own account, there is no need, for example, for an authorized provider of financial services or an authorized credit institution that makes use of high frequency algorithmic trading techniques merely for the purpose of providing financial services to third parties (e.g., brokerage services or portfolio management) to obtain an additional license covering “dealing on own account”.
The HFT Rules provide for a transitional period of six months for EEA entities, which ends on November 14, 2013, by which time entities must either have submitted an application to BaFin or have initiated the passporting process and must comply with the organizational requirements described below. BaFin has confirmed that it will not, during the transitional period, impose any sanctions or undertake any enforcement actions. Entities domiciled outside the EEA have an extended transitional period of nine months.
The HFT Rules impose additional organizational requirements on the following types of undertakings if they engage in algorithmic trading (as defined below):
providers of securities services that are required to be licensed (Wertpapierdienstleistungsunternehmen – broadly, similar in concept to an “investment firm” as defined in Art. 4 para. 1 no. 1 of MiFID);
management companies of Undertakings for Collective Investment in Transferable Securities (“UCITS”) and of Alternative Investment Funds (“AIFs”).
The key organizational requirements are that systems must be in place to ensure that: (i) trading systems are resilient, have sufficient capacity and are subject to appropriate trading thresholds and limits, (ii) no erroneous orders are transmitted, (iii) the system does not create or contribute to the creation of a disorderly market, and (iv) the trading systems cannot be used for a purpose that would infringe on market abuse rules or provisions of stock exchange rules and regulations.
In addition, such firms are required to (i) have in place arrangements that enable them to effectively deal with unforeseen failures of the trading system, (ii) fully review and properly monitor their systems, and (iii) document every modification of the computer algorithms employed by them.
Obligations to Provide Information
In addition to the organizational requirements outlined above, the HFT Rules introduce a new reporting regime that requires certain information to be provided to competent authorities on a regular basis. This regime came into force on May 14 of this year.
Providers of securities services that are engaged in algorithmic trading (defined in the HFT Rules as trading in financial instruments using a computer algorithm that automatically – i.e., without the need for human intervention – determines certain specific parameters of each single order, such as the decision whether an order is placed, the timing of the order, and the price or quantity of the order) are required, upon request from the competent authorities, to provide information on the algorithmic trading strategies used, the systems utilized and details regarding specific parameters and thresholds employed by those systems. Competent authorities can also require information for the purpose of enabling them to determine whether the organizational requirements mentioned above are being complied with.
It is unclear whether a provider of securities services that is a member of a German stock exchange – or an entity that is being granted direct electronic access by such a member – can also be required by the competent authorities to provide the aforementioned information at any time without reason, or whether each request has to be justified.
By contrast, if the relevant provider of securities services is not a member of a German stock exchange, the HFT Rules explicitly state that competent authorities are only empowered to request information provided that they are able to demonstrate (which may need to be substantiated if challenged in court) that the requested information is necessary for ongoing compliance monitoring reasons.
It is therefore conceivable that members of a German stock exchange may be subject to a stricter regime as regards disclosure than the regime as it applies to non-members. In practice, however, it may be expected that both regimes will be applied by competent authorities without significant deviations.
The HFT Rules provide for an obligation to uphold an appropriate ratio between (i) the orders entered, modified or cancelled, and (ii) the trades that are actually executed (the so-called “appropriate order-to-trade ratio”). This obligation also came into force on May 14 of this year.
These obligations only apply to members of a German stock exchange or members of a multilateral trading facility supervised by the BaFin. As long as an entity merely engages financial intermediaries (i.e., brokers) to trade with financial instruments on the aforementioned trading venues, it will not be subject to this obligation.
The HFT Rules generally deem an order-to-trade ratio to be appropriate if it can be deemed to be economically reasonable taking into account the overall trading volume of the relevant financial instrument, the specific market situation and the function of the trading participant concerned.
More detailed guidelines as to the appropriateness of the order-to-trade ratio may be issued with respect to multilateral trading facilities by the German Federal Ministry of Finance (Bundesfinanzministerium) in due course.
Moreover, the stock exchanges (and the operators of multilateral trading facilities) are required by law to stipulate more detailed provisions in their exchange (multilateral trading facility) rules and regulations. So far, there do not appear to have been any proposed amendments to existing exchange rules and regulations which are designed to implement this requirement.
A violation of the obligation to uphold an appropriate order-to-trade ratio could, among other things, result in the suspension or the withdrawal of the membership of the relevant stock exchange.
Algorithmic Trading and Market Manipulation
Section 20a of the WpHG prohibits certain trading practices that entail so-called “market manipulation” and makes it unlawful to initiate transactions or issue purchase or sell orders that have the potential to generate false or misleading signals affecting supply, demand, the stock exchange or market price of financial instruments, or that create an artificial price level. Further details on this ban on market manipulation are set forth in the Regulation to Further Define the Prohibition against Market Manipulation (Marktmanipulations-Konkretisierungsverordnung – “MaKonV”).
The HFT Rules will amend the MaKonV explicitly to state that certain trading practices executed using computer algorithms are to be viewed as market manipulation – for instance, purchase or sell orders may be deemed a false or misleading signal if they are generated by means of a computer algorithm that automatically places, modifies or cancels orders and:
causes, or may potentially cause, the disruption of, or delays in, the functioning of the trading system;
makes, or may potentially make, it difficult for third parties to identify genuine purchase or sell orders in the trading system; or
creates, or may potentially create, a false or misleading impression about the supply of, or the demand for, a financial instrument.
In addition to the above, the HFT Rules require stock exchanges (and operators of multilateral trading facilities) to charge separate fees for excessive use of their trading systems, in particular as a result of entering, changing or cancelling a high number of orders.
Exchanges (and operators of multilateral trading facilities) are granted considerable leeway in structuring these separate fees, but they must be set at a level that effectively prevents excessive use of the trading systems and the resulting negative impact on system stability.
Apart from these extra fees, the HFT Rules do not impose additional monetary charges (for example, taxes) that are directly attributable to high frequency trading.
Summary and Outlook
Germany is not the only country embarking on the difficult task of regulating high frequency trading. At the European Union level, for example, the European Commission will likely revise MiFID to introduce themes contained in the HFT Rules. The German HFT Rules, however, go beyond these likely revisions in material aspects by significantly modifying the current German regulatory regime governing the trading with financial instruments and the operation and functioning of stock exchanges and other trading venues (i.e., multilateral trading facilities). The ramifications go beyond those entities directly involved in the trading of financial instruments (e.g., operators and members of stock exchanges and providers of securities services) and also affect persons who indirectly participate in the trading of financial instruments, such as entities that are being granted direct electronic access to trading venues and that deal merely on their own account.