Preventing and detecting disorderly trading

In order to mitigate the risk of disorderly trading triggered by algorithmic trading activity, EU MIFID II established a set of requirements to both investment firms and trading venues.

Requirements for investment firms

EU MIFID II Article 17 (1) requires that “an investment firm that engages in algorithmic trading shall have in place effective systems and risk controls suitable to the business it operates to ensure that its trading systems (…) prevent the sending of erroneous orders or the systems otherwise functioning in a way that may create or contribute to a disorderly market.”

Within this scope, firstly, (RTS 6, Art. 5) investment firms are required to test their algorithms prior to deployment or substantial update, ensuring that they:

• Do not behave in an unintended manner;
• Comply with all trading venue rules and regulatory requirements;
• Do not contribute to disorderly trading conditions;
• Continue to work effectively in disorderly market conditions;
• Can be promptly switched off, whenever necessary.

In addition, investment firms are required to establish:

• (RTS 6, Art. 15) Pre-trade controls, to avoid the entry of orders that may disorder the market, with such controls being based on:
• Order price;
• Order value;
• Order volume;
• Frequency of messages to order books (submission, modification or cancellation);
• Frequency at which an algorithmic trading strategy is executed.

• (RTS 6, Art. 16) Real-time monitoring, to look for signs of disorderly trading, with a system that includes real-time alerts and established processes that allow for remedial action, and should be performed by:
• The trader in charge of the trading algorithm or algorithmic trading strategy; and 
• A risk management/control team that is hierarchically independent from the trader;

• (RTS 6, Art. 12) Kill functionality, as an emergency measure, allowing to any or all submitted orders to be cancelled immediately.

Requirements for trading venues

(RTS 7, Art. 10) Trading venues are required to demand their members to certify that the algorithms they deploy have been tested to avoid contributing to or creating disorderly trading conditions;

(RTS 7, Art. 18) In addition, trading venues are required to have arrangements to prevent disorderly trading, such as: 

• Limits for the number of orders sent by a member per second; 
• Mechanisms to manage volatility; 
• Pre-trade controls; 
• Ability to suspend a member;
• Kill functionality, to cancel all orders submitted by a member.