Mifid II, set to come into force at the start of January 2018, will have far-reaching consequences for large numbers of European market participants, not only from an operational perspective, but also, significantly, in terms of their technology stacks. In the first installment of this three-part series, Ullink’s Richard Bentley explains how, where and why the consequences of the Directive will be most keenly felt.
While much has been written about the impact of Mifid II on the capital markets industry, little has been said regarding the implications for the technology that underpins it. Mifid II will certainly have a significant impact on market structure, but its impact on the underlying technology is just as profound. Technologies such as FIX engines, market gateways, order and execution management systems (OEMSs), booking systems, algo engines, risk systems, smart order routers and more will have to change. Upgrading this technology to “keep the lights on” come January 2018 is consuming most of the time and budget of market participants’ IT departments—and will do so for some time to come.
In this series of three articles, we examine some of the technology impacts from the perspective of the sell side, centered on electronic order execution and the workflows around it. In the first article, we focus on those activities that happen from receipt and validation of a client order through to deciding how and where to execute it. The next instalment considers execution itself, including requirements for monitoring and intervention during execution, while the final piece looks at the implications of Mifid II for post-trade workflows such as reporting and recordkeeping, in terms of supporting technology.
Client Connectivity and Messaging
The FIX protocol has become the industry standard for electronic messaging, especially for the transmission of client order details to sell-side counterparts. Mifid II materially impacts these flows and the subsequent transmission of trades from broker to client. The changes are many—impacting the format and content of existing FIX message fields and adding new fields for reporting and recordkeeping purposes.
Some of these changes will require technology upgrades. For example, changes to granularity of timestamp fields—Mifid II mandates microsecond timestamps for some flows—affect the technology stack, which generates and validates the new data formats. Even for non-high-frequency trading (HFT) flows, as market operators upgrade application programming interfaces (APIs) to add microsecond precision, those messages must flow through to originating clients. In addition, as non-HFT order flow trades on markets where HFT is present, microsecond timestamping of all steps in the execution path will be required to truly assess execution quality under the new, tighter best-execution rules.
Brokers must also determine whether all required information should be passed with each client order, or if some can be pre-transmitted by the buy side and used by the sell side to enrich client order information prior to reporting. In both cases, however, brokers will be forced to update their FIX “rules of engagement” specifications and their message-validation rules, and undertake costly re-certifications of their buy-side trading partners.
Instrument Reference Data
Once an order is received by the broker, a sales trader will typically have to decide what to do with it. This process becomes more complex under Mifid II. Depending on the instrument, consideration needs to be made regarding whether it trades in a “liquid market,” whether the order is large-in-scale (LIS), the instrument’s standard market size (SMS), and more. To support this requires extra reference data, which needs to be processed and mapped from new sources such as the European Securities and Markets Authority (Esma), as well as enhancements to existing market data feeds. This data needs to be accessible to the OMS, as it impacts core business logic, and much of it is needed for reference by the trader via desktop OMS screens.
In a recent study sponsored by Ullink, 75 percent of sell-side respondents indicated that they are actively upgrading or planning to upgrade their OMS this year. The impact on data models, business logic and end-user interfaces as a result of reference data changes is one reason for this. Other reasons include definitional changes to things like trading capacity, which impacts how client orders can be executed and reported.
One of the consequences of Mifid II is the push for brokers to become systematic internalizers (SIs) in order to execute client orders outside of regulated markets, or on multilateral/organized trading facilities (MTFs/OTFs). It is expected that many brokers will do so, as trading with SIs will become a popular option under Mifid II as such trades are not subject to certain constraints with respect to trading in dark pools, for example. Operating as an SI introduces many requirements for technology to support quote generation and market-making activities. There are also many obligations an SI must fulfill, such as pre-trade publication of quotes to the market (so called “pre-trade transparency”) and ensuring that client orders are matched in line with previously published quotes. An impact of the new rules concerns how an SI will handle traditional request-for-quote (RFQ) flows, needing to marry the quote generation in response to a client RFQ with the obligations around pre-trade transparency. This may require further changes to existing OMSs and the extension of the quote-generation logic to ensure quotes are published in a timely manner.
Algos and Smart Order Routers
Mifid II will have a major impact on algorithmic trading. The provisions for mandatory testing of algos will consume significant effort on an ongoing basis, and the need to add new tags to precisely identify the origins of an algo order will similarly require some systems work. More fundamentally, the changes in market structure as a result of the regulation will mean that many algos need to be re-examined, as the basis changes for deciding when, where and how market orders should be executed. As a consequence of this, the role of the smart order router (SOR)—a distinct system external to the algo box—will become more important. In Europe, the current generation of SORs for cash equity markets emerged 10 years ago with the fragmentation of liquidity generated by the original Mifid legislation. Now, as Mifid II tightens rules around best execution and extends them to other asset classes, the current generation of SORs needs to be upgraded. And dealing with the characteristics of different asset classes, plus additional data requirements for evidencing best execution, will require more than a simple evolution.
Considering cash equities alone, developments like the increasing importance of SIs, constraints on dark pool-trading, and the emergence of new block liquidity venues for LIS orders require changes to the core routing logic of the SOR. For example, the indication of interest (IOI)-like models being deployed for new LIS venues require completely different workflows to markets built around displayed central limit order books operating under continuous trading. Like its lighter-touch ancestor, Mifid II will engender a new generation of SOR technology.
Risk and Compliance Checks
Mifid II has much to say on the subject of pre-trade risk. New risk checks are mandated around order price, total value, order volume, and message rates. The latter is particularly interesting, being concerned with prevention of disorderly markets caused by badly coded algorithms, and of high order-to-trade rates common to certain types of high-frequency trading. This may have significant impact on market-making engines as well as the pre-trade risk systems which police them.
Many pre-trade risk technologies already support most or all of the risk controls mandated by Mifid II, but changes to visibility, control, alerting and audit requirements will cause challenges. For example, Mifid II mandates real-time alerting of breaches of risk limits and monitoring by independent compliance personnel, raising questions of user access control and the timeliness of notification of breaches. In addition, any modifications to risk limits—to change threshold parameters or enable/disable or otherwise change the scope of controls—need to be captured in auditable form, and this will require many pre-trade risk engines to be upgraded.
The areas identified above represent only a small slice of the impact that Mifid II will have on existing trading technology and infrastructure. In the next article of this series we move beyond pre-trade to look at some of the systems concerned with the actual execution of client orders, including market gateways, monitoring systems, and kill switches.
Richard Bentley is chief product officer at Ullink, a Paris-based provider of multi-asset trading technology and infrastructure to the buy side and sell side.