International Review of Equity Market Structure Regulation: Phase I (2019)

“Lit” trades are executed on venues with pre-trade transparency, meaning that orders to buy and sell a stock (including size and price information) are publicly displayed before execution of the trade. Trades that take place in the “dark” are simply trades that are executed on venues without pre-trade transparency. We note that all five jurisdictions that we reviewed require post-trade transparency, meaning that once a trade is executed the size and price information of the trade must be publicly reported.

Dark trading is prohibited in Mainland China. In Hong Kong, the HKEx prohibits dark trading on the exchange, but multilateral trading venues and broker-dealer internalizers may engage in dark trading. In Japan, the FSA prohibits dark trading on the Tokyo Stock Exchange (“TSE”), but multilateral trading venues and broker-dealer internalizers may engage in dark trading. In the European Union, exchanges and multilateral trading venues may engage in dark trading, however dark trading on both venues is subject to limits. These limits are based on the total amount of dark trading in a stock per venue and the total amount of dark trading in a stock across all trading venues. For quotes up to and including the standard market size, broker-dealer internalizers (“systematic internalisers” in the EU) must: (i) publicly publish pre-trade quotes for shares with a liquid market and (ii) make pre-trade quotes for shares without a liquid market available to clients upon request. Finally, in the United States, exchanges, multilateral trading venues and broker-dealer internalizers may engage in dark trading. However, multilateral trading venues in the United States must publicly display orders in a specific stock if they display orders to participants on their trading venues and execute more than 5% of total trading volume across all trading ven-ues in that stock – though in practice, no trading venues exceed that threshold.

Dark Trading: Summary Chart

Broker-dealers stand at the heart of the equity market structure of each of the five jurisdictions, as they are responsible for routing investor orders to trading venues for execution. Although each jurisdiction requires that broker-dealers register with a regulatory agency, each jurisdiction has different requirements as to how broker-dealers should handle client orders–the duty of best execution–and the related disclosures that they must provide their clients as to order routing decisions and execution quality. These requirements are critical for an efficient equity market structure, as they enable investors to identify the broker-dealers that are most likely to provide them with the best terms of execution (such as best price, largest size, fastest execution).

In Mainland China and Japan, there is limited regulatory guidance as to the duty of best execution. The CSRC requires that broker-dealers treat their clients fairly and route client orders to the relevant exchange according to the instruction of the clients. In Japan, broker-dealers must adopt a policy and method for executing orders from customers under the best terms and conditions, but no further guidance is provided as to what is meant by best terms and conditions. As a result, execution quality is primarily ensured by customer monitoring and selection of their broker-dealer. 

The duty of best execution is more detailed in Hong Kong, the European Union and the United States. In Hong Kong, the SFC requires that broker-dealers execute client orders on the best available terms, which include (1) price, (2) cost, (3) speed of execution, (4) likelihood of execution, (5) speed of settlement, (6) likelihood of settlement, and (7) the size and nature of an order. In the E.U., broker-dealers must take “all sufficient steps” to obtain the best possible results for their clients, taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order. In the U.S., the Financial Industry Regulatory Association (“FINRA”), the self-regulatory authority for U.S. broker-dealers, requires broker-dealers to “use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.”

As noted earlier, each of the five jurisdictions requires post-trade transparency. Post-trade transparency is relevant to the duty of best execution as it provides investors the ability to assess whether the price and terms of execution received for their orders is generally consistent with their expectations when they submitted their orders to the broker-dealer. Each of the five jurisdictions that we reviewed also has additional requirements as to record-keeping and disclosure requirements for broker-dealer order routing decisions and execution quality that provides inves-tors with further insight as to their broker-dealer’s duty of best execution.

In Mainland China, these requirements are limited, as broker-dealers are solely required to “keep under safe custody the records of their clients’ orders and their order routing activities.” In Japan, broker-dealers must disclose their best execution policy to clients; however there are not specific requirements as to order routing decisions (how a broker-dealer chooses among trading venues) or execution quality achieved on a specific trading venue or across all trading venues. In Hong Kong, broker-dealers are required to adopt policies and procedures that address disclosure to clients of best execution arrangements including carve outs and the exclusive use of affiliates, connected parties and third parties, including any payments for order flow.

The disclosure requirements related to best execution in the European Union40 and United States go significantly further than the other jurisdictions, as broker-dealers must disclose the trading venues that they route to and how they make such routing decisions, including quantitative execution quality considerations. In the United States, payment for order flow arrangements must be disclosed. In the European Union, payment for order flow arrangements are prohibited. Finally, in the European Union and the United States, trading venues are required to disclose quantitative metrics as to their execution quality (e.g. execution prices on the trading venue as compared to the best price available across all trading venues) that further facilitate investors’ ability to assess the execution quality achieved by their broker-dealers.

In each of the five jurisdictions that we reviewed, the majority of stock trades are executed on exchanges, particularly in Asian jurisdictions where more than 90% of stock trades are executed on exchanges. We therefore focus our attention on the regulation of the fees that exchanges may charge broker-dealers for accessing an exchange, executing client orders or for market data that can only be accessed from an exchange. We generally find that the regulatory authority in each jurisdiction must approve exchange fees but have varying standards of review.

In Mainland China, the CSRC together with the National Development and Reform Commission have the express authority to set fees at stock exchanges. Regarding criteria used to determine fee levels, the CSRC has stated that “market size and environment” have been factors. In Hong Kong, exchange fees must be specified in rules approved by the SFC. In making its decision on fee rules, the SFC must take into account the level of competition, if any, in Hong Kong for the matter for which the fee is to be imposed and the fees, if any, imposed by another recognized exchange controller or recognized exchange company or any similar entity outside Hong Kong for equivalent matters.

In Japan, exchanges are required to obtain FSA approval for the fees that they charge. Exchanges are also required to perform benchmarking analysis and/or impact analysis, and the FSA must determine whether the structure of the model or the fee charge is fair or unduly discriminatory. The FSA evaluates the reasonableness of exchange fees by considering service provided vs. fees charged, operational cost, value added, comparable fees of other trading venues and competition factors.

In the European Union, exchange fees must be transparent, fair and non-discriminatory as determined by the competent authority in the E.U. Member State. Generally, exchanges must charge broker-dealers similar fees for similar services. With respect to market data fees, exchanges must provide market data on a “reasonable commercial basis.” As a result, market data prices must be: (i) based on costs of producing and disseminating such data, including a reasonable margin; (ii) offered on a non-discriminatory basis to all clients; (iii) charged according to the individual end-user’s use; and (iv) available without being bundled with other services.

In the United States, exchange rules must provide for the equitable allocation of reasonable fees and other charges among its broker-dealer members, not permit unfair discrimination and not impose any unnecessary burden on competition. Exchange fees do not require pre-approval and are effective upon filing with the SEC, but the SEC may immediately temporarily suspend pro-posed fees if they appear inconsistent with the requirements of the Exchange Act and institute proceedings to determine whether the fee should be approved. In addition, the consolidated market data fees charged by exchanges must be fair and reasonable. Further, there is an explicit cap on “access” fees (30 cents/100 shares) that exchanges can charge for publicly displayed orders. In April 2019, the SEC launched a transaction fee pilot to explore further reducing the cap on access fees. Although the pilot remains on hold pending the resolution of legal challenges raised by exchanges, the data collection associated with it has commenced. 

A minimum tick-size refers to the smallest pricing increment at which a trading venue can display (quote) order interest to buy or sell a stock. Regulators and/or trading venues impose minimum tick sizes to encourage displayed liquidity at specific minimum spreads between the price bid and offered for stocks. Minimum tick sizes may be based on the fundamental supply and demand for a stock, on a stock’s price, or on a commonly used price measurement such as 1/100th of a U.S. dollar.

In Mainland China, the CSRC must approve tick-size rules on the Chinese exchanges. On the Shanghai and Shenzhen Stock Exchanges, the minimum tick sizes are RMB 0.01. In Hong Kong, the SFC must approve the tick-size rules on the HKEx. Tick sizes on the HKEx vary based on share price, with lower-priced stocks having smaller tick sizes. Operators of multilateral trading venues in Hong Kong can determine their own tick-sizes, but they remain subject to the SFC’s general regulatory authority and ability to impose conditions on their licenses. In Japan, the FSA must approve the tick-size rules on Japanese exchanges. Tick sizes on the TSE vary based on share price, with lower-priced stocks having smaller tick sizes. Operators of multilateral trading venues can determine their own tick-sizes subject to the approval of the regulatory authority.

In the European Union, tick sizes must be based on the liquidity of a stock as determined by the average daily number of transactions in that stock on the most relevant market. In the United States, the SEC requires that stock exchanges and multilateral trading venues adopt a minimum tick size of $0.01 for all stocks with a price above $1.00.

In modern equity markets, aspects of the trading process that were traditionally done manually, such as execution and order-routing, are now automated. Algorithmic trading—trading in which computers are involved in making trading decisions with limited human involvement—has become increasingly common. High frequency trading (“HFT”) refers to a subset of algorithmic trading that relies on processing information from trading venues and entering orders at trading venues at high speed. Accordingly, HFT is characterized by the use of special infrastructure to minimize latencies—the time it takes to send data to a particular end point (and potentially back again).

HFT strategies fall into three basic categories that have always existed in equity markets: First, market making which involves providing liquidity to the market by maintaining limit orders on both sides of trades. Market makers must be able to quickly assess changes in supply and demand for stocks and promptly update the prices at which they are willing to buy and sell. Second, HFT strategies also include arbitrage strategies, whereby arbitrageurs identify price discrepancies that arise between portfolios of assets or the same assets on different trading venues and conduct trades that bring those prices back in line. Third, directional HFT strategies involve trading rapidly as new information enters the market, which helps make the price discovery process more efficient and improves the accuracy of stock prices. HFT strategies typically feature a high volume of orders (which, in line with the strategies described, may be revised or cancelled shortly after sub-mission) and very low average profits per trade. They also usually involve ending the trading day with as relatively neutral or flat risk a position as possible (that is, not carrying significant, un-hedged positions overnight).

The prevalence of HFT strategies varies cross jurisdictions. HFT is common in the United States, accounting for approximately 50% of equity trading volume. Similarly, approximately 40-50% of trades on the Tokyo Stock Exchange, Japan’s primary equity trading venue, are placed through servers co-located with the exchange’s trading system. Estimates of trading volumes in the European Union and Hong Kong are less reliable but generally show that HFT strategies constitute a significant percentage of overall trading volume. In Mainland China, by contrast, investors employ various forms of algorithmic trading, but the use of standard HFT strategies is limited by certain market structure barriers. The cost of trading in Mainland China is relatively high and network connection latency levels on Chinese exchanges are not conducive to rapid trading. In addition, equity trading in Mainland China is subject to settlement regulations that forbid selling securities until they are settled—typically on a T+1 basis.

The jurisdictions reviewed in this report also differ with respect to how they regulate algorithmic trading and HFT. Mainland China, for example, does not directly regulate either.

Hong Kong regulates all electronic trading of securities and futures, including algorithmic trading, but it does not specifically regulate HFT; however, the regulatory requirements that apply generally to algorithmic traders apply to investors that employ HFT strategies. The SFC requires that firms engaged in electronic trading, or firms that provide electronic trading platforms, adopt risk controls and provide clients with adequate disclosure regarding the risks of electronic trading. The SFC also imposes specific testing and recordkeeping requirements on algorithmic traders.

In the European Union, algorithmic traders must notify regulators, must put in place extensive risk controls, and must comply with comprehensive recordkeeping requirements. Firms that employ market making algorithms must also agree to do so on a continuous basis. HFT, defined as a subset of algorithmic trading that is intended to minimize latency and involves high-message rates, such as orders, quotes and cancellations, is subject to additional regulations.

Japan has adopted regulations that apply specifically to HFT. Whether an investor is considered to engage in HFT depends on whether their trading system is located close to a trading venue. HFT firms are required to register with the FSA, provide the FSA with trading information and adopt risk controls specified in supervisory guidelines.

In the United States, firms engaged in algorithmic trading or HFT are either regulated as broker-dealers or, in the case of a trader obtaining “sponsored access” to trade on an exchange through a broker-dealer, subject to supervision by the broker-dealer providing sponsored access. In either case, they are subject to stringent risk controls and disclosure requirements to prevent erroneously disruptive trading activity.

Volatility controls are intended to minimize extreme price volatility in stocks that can be disruptive to an orderly trading environment. Volatility controls include (i) market-wide trading halts or “circuit breakers” or (ii) circuit breakers for individual stocks that trigger when there is significant price volatility during a specified period of time. Another type of volatility control is a “kill switch” whereby a broker-dealer is required to adopt a mechanism to automatically halt their own trading based on potentially erroneous trading activity.

In Mainland China, there is no regulatory requirement that exchanges adopt market-wide circuit breakers and none presently exist. Exchanges in Mainland China have adopted individual stock circuit breakers that trigger when a stock’s price fluctuates by 10% over a specified period of time. In Hong Kong, there is also no regulatory requirement imposing a market-wide circuit breaker and none presently exist. However, the HKEx has adopted individual stock circuit breakers that trigger when a stock’s price fluctuates by 10% over a pre-specified period of time. The HKEx also mandates that electronic traders adopt kill switches to immediately halt trading, but does not specify when kill switches must be executed. In Japan, there is also no regulatory requirement imposing a market-wide circuit breaker and none presently exist. The TSE imposes individual stock circuit breakers that vary based on the absolute price of a stock. Neither the FSA nor the TSE require that broker-dealers adopt kill switches.

In the European Union, there is no regulatory requirement for market-wide circuit breakers, and neither the London Stock Exchange, Euronext, nor Deutsche Bourse have adopted any. Exchanges and multilateral trading venues are required to adopt circuit breakers for individual stocks when there is significant price movement during a short period. A pre-defined statistically supported method must be used. Broker-dealers engaged in algorithmic trading are also required to adopt kill switches allowing them to cancel all of their unexecuted orders with immediate effect, when the broker-dealer determines that doing so is necessary.

The United States, through a rule proposed by the US exchanges and approved by the SEC, is the only jurisdiction we reviewed that imposes market-wide circuit breakers at price declines of 7% (Level 1), 13% (Level 2) and 20% (Level 3) in the S&P 500. There can be only one 15-minute trading halt per day for a Level 1 or Level 2 market decline. A Level 3 market decline halts trading for the remainder of the trading day. The SEC also approved a rule proposed by the US ex-changes and FINRA introducing individual stock circuit breakers that apply when a stock’s price fluctuates from 5-20% depending on the price and liquidity of the stock. Neither the SEC nor the exchanges impose mandatory kill switches on broker-dealers.

Volatility Controls: Summary Chart

Stock exchanges and other trading systems

There are currently two stock exchanges for publicly-listed stocks in Mainland China, the Shanghai Stock Exchange and the Shenzhen Stock Exchange, each formed as membership organizations supervised by the CSRC. The two stock exchanges were established in 1990 and there have been no applications to establish a new stock exchange since then.

The Shanghai Stock Exchange has two boards, the main board and the STAR Board. On the main board, 1,464 companies are listed, including 1,457 companies with A-Shares and 51 with B-Shares with a total market capitalization of 33.7 trillion RMB (as of March 2019). Listing requirements for the main board require at least 3-years of profitability and profit of more than 30 million RMB in the past years. The STAR Board was launched in July 2019 and lists 29 companies (as of mid-2019). As explained in greater depth below, its listing standards allow non-profitable and low-revenue companies to be listed under certain circumstances.

The Shenzhen Stock Exchange has three boards and over 2,000 companies are listed, with total capitalization of 23.7 trillion RMB. The three boards are: 1) the main board (463 A-share companies and 48 B-share companies); 2) SME Board (931 companies); and 3) ChiNext Board (749 companies). Listing requirements for the main board and the SME Board are the same as the listing requirements of Shanghai Stock Exchange. The ChiNext Board only requires 1-2 years of profitability (and may be lowered further).

The National Equities Exchange and Quotations Co., Ltd.121 (“NEEQ,” or The New Third Board) was launched in 2012 and serves as a trading system for shares of public companies not listed on the Shanghai or Shenzhen stock exchanges. As of December 2018, the NEEQ listed 10,691 companies, with a total market capitalization of 3.45 trillion RMB. NEEQ is directly regulated and supervised by the CSRC.

NEEQ-traded stocks are only accessible to Qualified Investors (two years of experience in securities investing and 5 million RMB worth of securities in assets). Companies primarily trade on the NEEQ if they have been delisted from one of the main exchanges (for violating one of the listing requirements) or if they do not satisfy them in the first place (for example, early stage companies). NEEQ is highly significant because it is a primary channel through which not-yet-profitable high-growth firms companies raise capital. However, all NEEQ companies that wish to go public must first go through the same CSRC-administered registration process to be listed on the Shenzhen or Shanghai stock exchange.

In 2016, the NEEQ introduced a two-tiered classification framework for the NEEQ that splits companies listed on NEEQ into two categories of companies: (1) basic level; and (2) innovation level, resulting in two tiers of NEEQ listing requirements. As of September 26, 2019, there were 8,556 “basic” level companies and 686 “innovation level” companies.

NEEQ listing requirements for basic level companies include: (1) “be lawfully established”; (2) have a “well-defined business plan,” “good corporate governance,” “a legitimate business”, and “clear equity structure”; (3) conduct issuance and transfer of shares in accordance with the law; 4) “be recommended and supervised by a legitimate brokerage”; and (5) “exist for two or more years.” There are not quantitative thresholds, such as minimum book value or profitability requirements. To be listed as an innovation level company requires meeting all of the criteria above, and also meeting one of three additional requirements related to profitability, liquidity, or the ability of the company to grow.

There are also approximately 40 regional stock trading platforms that serve as OTC markets for companies within the region of the platform. According to the World Bank:

“Companies trading on these platforms cannot engage in a public offering of securities; they are only allowed to sell their securities to qualified investors through a private placement. Thus, as per the definition of public offering, they cannot have more than 200 shareholders. Secondary market trading also is restricted to qualified investors. As per recent guidance issued by the [State Council] such investors must be institutional investors or individuals with more than 500,000 RMB in financial assets. Trading mechanisms vary; but pursuant to the [State Council] instruments no trading platform may establish a market-making system or provide a continuous auction or electronic matching capability, and a lapse of 5 days must take place between the moment that an investor buys a securities and the moment in which he/she sells it.”

The size of these regional exchanges can be quite large – for example, Shenzhen’s regionally-administered exchange has a market cap of 416 billion RMB and has more companies listed (13,589) than NEEQ (~10,500). According to researchers at Tsinghua University, “Ventures can apply online and, if accepted, provide whatever company information they choose and can offer shares at a price they set.”

In November 2018, PRC President Xi Jinping announced Shanghai Stock Exchange plans to create a technology-focused trading board with more lenient trading regulations. Subsequently, in July 2019, the Shanghai Stock Exchange launched its technology-focused STAR Board with 25 listed companies. Notable regulatory characteristics of the STAR Board that differ from the SSE’s main board include:

• A much less stringent IPO application process that resembles a disclosure-oriented, registration-based process, although the CSRC can still intervene to reject SSE-approved listings. 
• Allowing unprofitable companies to go public, as long as those companies exceed certain market capitalization thresholds and also meet certain revenue levels, exceed R&D investment thresholds, focus on certain government-approved businesses/products, and/or meet other SSE-set criteria.
• No price limit for the trading of a stock during the first five trading days it is listed on the STAR Board and a daily price up/down limit of 20% for the stock beginning on the sixth trading day after its listing (compared with 44% on the first day and 10% on subsequent days for SSE and SZSE listed companies).
• Requiring that STAR Board market participants have at least: 1) a securities and funds account daily average balance of no less than RMB 500,000 (excluding funds and securities acquired via margin financing or securities lending) for 20 trading days prior to applying to trade STAR Board-listed securities; and 2) already participated in securities trading for over 24 months. According to one report, there are approximately 3 million current A-share individual account holders who meet the 500,000 RMB threshold.

Exchange trading systems

Securities trading on the exchanges is conducted via call auction or continuous auction, two different types of order-driven markets. Call auction refers to the process of one-time centralized matching of buy and sell orders accepted during a specified period, while continuous auction refers to the process of continuous matching of buy and sell orders on a one-by-one basis.141 Relevant rules and structures of the call auction and continuous auction processes are set forth below:

The trading systems of the two exchanges accept orders from their members between 9:15- 9:25 (opening call auction), 9:30- 11:30 and 13:00- 15:00 on each trading day.

• After a 9:15 to 9:25 opening call auction, the continuous auction begins, which runs from 9:30 to 11:30 and from 13:00 to 15:00, except for the securities whose trading is suspended and resumed during trading hours. The buy or sell orders which are not executed during the call auction are automatically entered into the continuous auction.
• From 14:57 to 15:00, a call auction is executed for the market closing.

During the continuous auction, orders are matched and executed based on the principles of price priority and time priority. The principle of price priority means: “a priority is given to a higher [priced] buy order over a lower [priced] buy order and a priority is given to a lower [priced] sell order over a higher [priced] sell order.” The principle of time priority means: “for orders with the same bid price or offer price, a priority is given to the order placed earlier.”

The Exchanges and NEEQ have established block trading systems to facilitate large volume transactions. Transactions above certain thresholds can be negotiated through an Exchange-administered negotiation system.

Compared with the Exchanges’ order-driven systems, the trading volume of the block trading system is very low. Across the Shenzhen and Shanghai stock markets, between February 2018 and February 2019, block trades represented less than 0.1% of the RMB volume of all trades. Block trades are not included in the Exchange’s real-time quotations and index calculation. Upon the completion of block trades on each trading day, their trading volumes are added to the total turnover of relevant securities. After the completion of block trades on each trading day, the Exchange will, in case of block trades of stocks or mutual funds, release the securities names, execution prices, trading volumes, and the names of brokerage branches involved.

In 2012, Shanghai lowered the minimum quantity requirements for A-share block trades to 100,000 shares or 600,000 RMB from 500,000 shares or 3,000,000 RMB.150 For Shenzhen, the minimum A-share block trade quantity is 300,000 shares and 2,000,000 RMB. In May 2017, the CSRC introduced rules increasing restrictions on block trading. According to the May 2017 rule change, “substantial shareholders are barred from selling their holdings through so-called block trades, in a manner that may ‘maliciously’ cause prices to plunge and hurt public confidence.”

Self-regulatory authority

The securities exchanges are self-regulatory organizations, which exercise real-time monitoring of unusual trading activities that may affect the trading price or trading volume of securities. The “Trading Rules” established by the Shanghai and Shenzhen stock exchanges (the “Exchanges”) related to these responsibilities include:

• When an Exchange member or its branches discovers any investor involved in unusual trading activities — as defined in the Exchanges’ Trading Rules – and believes such activity may seriously affect the order of the securities market, it shall “issue an alert and report to the Exchange in a timely manner.”
• In the event of unusual trading activities that have a serious effect on the price or trading volume of securities, the Exchange may conduct on-site inspections or off-site inspections and require relevant members and their involved branches to provide relevant information on involved investors.
  • Exchange members and investors shall coordinate with the Exchange in its inspections and provide relevant documents and information timely, truthfully, accurately, and completely.
  • In severe cases of unusual trading activities, the Exchange may take the following measures according to specific circumstances: (1) “oral or written warning”; (2) summoning the parties involved for a meeting; (3) “requiring relevant investors to provide a written commitment”; and (4) “restricting trading under relevant securities accounts”; and (5) reporting the matter to the CSRC. Shanghai Trading Rules specifically mention the following two CSRC-related measures: (1) “applying with the CSRC for freezing relevant securities accounts or cash accounts”; and (2) “filing with the CSRC for investigation and punishment.” 
• If an Exchange member violates any of the Trading Rules, the Exchange will order the member to make rectification and may, depending on seriousness of the circumstances, impose one or several of the following penalties: (1) “circulating a notice of criticism among members”; (2) “publishing a public censure in CSRC-designated media”; (3) “suspending or restricting trading”; (4) “revoking trading qualification”; or/and (5) “canceling membership.”

Alternative trading venues

According to the Securities Law, the trading of the shares of companies listed on an Exchange must take place within that Exchange. As a result, “securities traded on [Mainland] China’s stock exchanges are not cross-listed and trade on one exchange only.”

Article 39 of the Securities Law provides that “Shares, corporate bonds and other securities pub-licly issued pursuant to law shall be listed for trading on lawfully established stock exchanges, or transferred at other securities trading sites approved by the State Council.” No other trading sites have been approved by the State Council. 

As a result, there are no alternative trading venues. As reported in February 2019 IOSCO research, Mainland China does not allow dark pools and as further confirmed by MIT and NYU economists: “there are no dark pools with hidden orders in [Mainland] China, all orders are visible.”

Trading fees

The CSRC and the National Development and Reform Commission jointly determine member trading fees at stock exchanges; Mainland China is unique in giving regulators express authority to set the trading fees to be charged by trading venues. Brokers compete freely with each other to attract potential clients by offering competitive trading fees.

The CSRC has stated (in connection with a cut to trading fees) that fee schedules are determined in part by reference to market size and environment, with the aim of utilizing them for the development of markets and market infrastructure.

Market data

The Exchanges “will disseminate real-time quotations, indices, public information and other trading information in respect of securities trading on each trading day.”

The Exchanges each disseminate this data through wholly-owned subsidiaries, which offer three tiers of data access: (1) Level-1 real-time market data released through the subsidiary’s broadband broadcasting satellite system or the subsidiary’s internet service; (2) Delayed Level-1 market data transferred via the subsidiary’s internet service; and (3) Real-time Level-2 market data transferred via the subsidiary’s private network.

Level-1 data includes real-time information on the top five buy and sell offers for each stock. Level-2 data includes the best 10 buy and sell orders for each stock. Exchange members receive free access to Level-1 data. Non-members can purchase Level-1 data real-time or delayed from the Exchange at market prices set by the Exchange.

In 2006, the Shanghai Stock Exchange began to provide Level-2 market data through its subsidiary, and now charges members or third parties seeking to purchase this data an annual market price. The Shenzhen Stock Exchange also charges for Level-2 data fee service. The CSRC does not regulate the price of Level-2 market data.

The brokerage businesses of securities firms are (i) regulated by the CSRC and (ii) subject to the Exchange’s Trading Rules. In accordance with applicable CSRC rules and Exchange Trading Rules, securities companies must treat their clients fairly. Other notable rules and restrictions include:

• The brokers may not conduct internalized trades. Every order a broker receives must be routed to the relevant exchange according to the instruction of the clients.
• During the continuous auction, the Exchanges must disclose to Exchange members in real-time the five lowest offer prices and five highest bid prices (and respective quantities) for listed securities – this disclosure requirement is for transparency and also for the clients to supervise the operation of their broker.
• If the client suspects that their order is not receiving the best available price, then they can lodge a complaint with the Exchange or the CSRC. If, after the investigation, it is determined that a broker did not route a client’s order to the Exchange in a timely manner, then the Exchange will deal with the infraction in the event only its rules were broken, or if CSRC rules are broken, then the CSRC will deal with the infraction.

A securities firm cannot match the orders of its clients, and it must submit the orders of clients to an exchange in a timely manner and in the same order that a member received them from a client. Order-routing proceeds as follows:

• Upon the acceptance of an investor’s instruction, the broker shall place an order with the Exchange as instructed and “assume corresponding trading and settlement obligations.”
• The broker shall route orders on a timely basis to the Exchange trading system. Client orders needs to be time stamped when entering the order routing system of the securities firm, and a timestamp is also required when the order arrives at the exchange.
• After an order is matched by the trading system of the exchange, the Exchange must send a trade record to the member in real time.
• Exchange participants “shall keep under safe custody the records of their clients’ orders and their order routing activities.”

On the Shanghai and Shenzhen Stock Exchanges, the tick size for quotes and orders is RMB 0.01 for A-shares, RMB 0.001 for mutual funds shares, USD 0.001 for Shanghai-listed B shares, and HKD 0.01 for Shenzhen-listed B-shares.

Mainland China does not directly regulate either algorithmic trading or HFT. In the past ten years, mutual funds, securities companies and other professional investors have introduced algorithmic trading to generate and execute orders automatically. However, HFT is effectively absent from the stock market.

There are several structural barriers to HFT in Mainland China. The cost of trading in Mainland China is relatively high, which constrains HFT strategies that rely on executing a large volume of trades: trades on the Shanghai and Shenzhen Stock Exchanges incur stamp duties of 10 bps (paid by the seller) as well as other handling and regulatory fees (paid by both buyer and seller). In addition, the latency offered by Mainland China’s exchanges are also not considered fast enough for standard HFT strategies (price quotation refresh rates in Mainland China-listed securities typ-ically range from 5 to 0.5 seconds).

Moreover, according to trading rules on both the Shanghai and Shenzhen Stock Exchanges, “[s]ecurities purchased by investors shall [generally] not be resold before settlement.” Accordingly, a stock that is bought on day T and settled the night of T, cannot be sold until day T+1. (The T+1 trading rule is the same for the NEEQ.) The T+1 rule is prohibitive to most HFT strategies, which involve high turnover and holding limited overnight inventories. Notably, the T+1 rule was not instituted to target HFT; it was implemented by the CSRC in the 1990s, well before the advent of HFT.

The Exchanges impose a daily price limit on trading of stocks and mutual funds, with a daily price up/down limit of 10% for individual stocks and mutual funds and a daily price up/down limit of 5% for individual stocks under special treatment (ST shares or *ST shares) (generally defined as publicly listed firms that have reported negative profits for two years or more or that have a NAV below par value).

The price limit does not apply to any of the following cases on the first trading day: (1) IPO shares or closed-end funds; (2) secondary issuances; (3) shares whose listing is resumed after suspension; or (4) other cases as recognized by the Exchange. With CSRC approval, Exchanges may adjust the daily price up/down limit.

For IPOs and listing resumptions, a stock’s price may change by no more than +44% on its first day of trading relative to its offering price. In January 2019, Fang Xinghai, vice chairman of the CSRC was quoted saying that the CSRC “should review the first day trading cap for initial public offerings,” and that “he personally [thinks] it should be removed.”

In 2016, Shanghai/Shenzhen market-wide circuit breakers linked to the CSI 300 Index were removed. The circuit breakers were intended to control dramatic fluctuations in the overall market, but the consensus is that they had the opposite effect: the circuit breakers triggered more panic-induced selling, as investors wanted to sell shares before the circuit breaker was triggered.

Under the SFO, the only recognized exchange controller in Hong Kong is HKEx, which operates the only recognized exchange company, the Stock Exchange of Hong Kong Limited (“SEHK”). As of the end of March 2019, the SEHK had 2,346 listed companies with a total market capitalization of more than HK$33.8 trillion.

Off-exchange trading venues are permitted, but like exchanges they must be registered with and regulated by the SFC. Hong Kong’s statutory framework for off-exchange trading venues was introduced in 2003. In December 2015, after a series of enforcement actions related to auto-mated trading services provided by large financial firms, the SFC issued new regulations governing the operation of alternative liquidity pools. In an April 2018 report on off-exchange trading, the SFC noted that turnover on automated trading services fluctuated between 1% and 1.7% of total securities market turnover between October 2016 and September 2017. Thus, the vast majority of trading in Hong Kong takes place on the SEHK.

Stock exchanges

The HKEx is the only recognized exchange controller under the SFO, and it owns and operates the SEHK, the only stock exchange in Hong Kong. The HKEx is a listed company on the SEHK, and the Government of Hong Kong retains more than 5 percent of the shares. Under the SFO, the Financial Secretary (“FS”) has the power to appoint up to eight directors of HKEx. The appointment of directors by the FS is considered necessary to ensure adequate reflection of public interest and interest of the investing public in decision making by the HKEx. The board of the SEHK is appointed by HKEx as its sole shareholder, but the approval of the SFC is required for the appointment of the chief executive of the SEHK.

The HKEx and the SEHK perform self-regulatory functions in the Hong Kong financial markets. Under the SFO, a recognized exchange controller must ensure an orderly, informed and fair market in securities traded on the stock market. The SFO provides that a recognized exchange company must also ensure an orderly, informed and fair market in securities that are traded on that stock market or through the facilities of that company, weighing the interest of the public more heavily where it conflicts with the private interest of the recognized exchange company.

The SFO authorizes a recognized exchange company to make rules for the proper regulation and efficient operation of the market which it operates. However, rules of recognized exchange companies and rule amendments only have effect once approved in writing by the SFC. In addition, the SFC, after consulting the FS and the relevant exchange, can make statutory rules on a variety of matters relating to market activity, for example regarding the admission of exchange participants, that can preempt the rules of the exchange company. The SEHK has adopted trading rules that govern participation in its stock market.

Access to exchanges

An entity that wants to participate directly in trading equities listed on the SEHK must apply to become an exchange participant. The eligibility requirements and ongoing obligations of exchange participants are set out in the regulations of the SEHK. One of the eligibility criteria established by the SEHK is that exchange participants must be licensed corporations.

Trading information is disseminated directly to participants by the SEHK. The SEHK rules provide that all participants may use the software provided by the exchanges, by vendors or developed in-house. Participants are free to choose trading devices which suit their business require-ments and nature to access the trading systems. For example, the SEHK started offering co-location services in November 2012. All participants have equal opportunity to obtain co-location services, and among those participants who have trading systems at the co-location center, system access time and latency are equal.

Trading fees

Fees imposed by recognized exchanges controllers (such as HKEx) and recognized exchanges companies (such as SEHK) must be specified in rules approved by SFC. In making its decision on fee rules, SFC must take into account the level of competition, if any, in Hong Kong for the matter for which the fee is to be imposed and the fees, if any, imposed by another recognized exchange controller or recognized exchange company or any similar entity outside Hong Kong for equivalent matters. The SFC does not permit tailored or negotiated fees.

Each purchase and sale of securities on the SEHK incurs (i) a stamp duty imposed (0.1% of the value of the transaction, taxed to both the buyer and seller),227 (ii) an HKEx trading fee (0.005% of the price paid, charged to both the buyer and seller), (iii) an HKEx transaction levy (0.0027% of the price paid, charged to both buyer and seller), and (iv) an HKEx trading tariff (HK$0.50 payable per transaction). According to June 2018 statements by HKEx CEO Charles Li, “HKEX is considering whether to ask the government to reduce or remove [the 0.1%] stamp duty” on both sides of a trade in an effort to increase trading volume. Notably, HKEx’s fee structure does not discriminate between makers and takers of liquidity.

Alternative trading venues

Hong Kong’s regulation of off-exchange trading venues was introduced in 2003. Pursuant to the SFO, only LCs holding a Type 7 authorization (for providing automated trading services) and the registered persons of such authorized LCs can provide automated trading services (“ATS”). ATS operators that trade securities listed on the SEHK must be generally licensed to carry on the business of dealing in securities and specifically licensed to carry on the business of providing ATSs.

There are no statutory obligations concerning pre- and post-trade transparency for ATS. In regard to post-trade transparency, pursuant to the trading rules of the HKEx all trades conducted through ATS must be reported to the HKEx within one minute after execution (other trades that are executed off-exchange must be reported within 15 minutes). This allows the HKEx (and vendors) to provide consolidated post-trade information.

In December 2015, after a series of enforcement actions related to ATSs provided by large financial firms, the SFC issued new regulations governing the operation of alternative liquidity pools (“ALPs”). ALPs are electronic systems operated by broker-dealers through which the crossing or matching of orders (including the internalization of orders) is conducted anonymously without any pre-trade transparency (i.e., dark trading). The SFC has described ALPs as an electronic subset of ATS. Since they provide ATS, ALP operators are required to report and flag to the HKEX all transactions conducted on their ALPs within one minute after trade execution.

Only institutional investors, including professional/experienced investors with a net worth of over HK$40 million or an investment portfolio of at least HK$8 million, are allowed to use ALPs. Notably, as of 2016 retail investors account for approximately 25 percent of trading value on the SEHK.

There is no explicit statutory requirement for exchanges to provide pre-trade transparency as to the best bid and ask quotations and market depth for stocks. However, the trading rules of the SEHK prohibit dark trading, so pre-trade transparency exists in practice. In addition, foreign trading venues are prohibited by SEHK regulations from facilitating off-exchange dark trading of SEHK-listed stocks in Hong Kong.

Likewise, there is no statutory requirement for post-trade transparency, but it is mandated by the trading rules of the SEHK. Post-trade information includes last traded price, day high, day low, closing price and trading volume. Through HKEx-approved information vendors, investors can access live feeds and 15-minute delayed feeds including trade times, prices and quantities. In addition, HKex also provides end-of-day trade data by security, including turnover by volume in HK dollars (HK$). Further, SEHK rules apply post-trade transparency obligations to trades executed off exchange by exchange participants: off-exchange trades must be reported to the SEHK within 15 minutes after the conclusion of the transactions.

The best execution provision of the SFC’s Code of Conduct requires licensed corporations (“LCs”) acting for or with clients to “execute client orders on the best available terms.” LCs are the Hong Kong-equivalent of U.S. broker-dealers.

In January 2018, the SFC issued a circular to licensed corporations on best execution. The circular emphasizes that “sufficient steps should be taken to obtain the best available terms when executing client orders, taking into account” factors such as (1) price, (2) cost, (3) speed of execution, (4) likelihood of execution, (5) speed of settlement, (6) likelihood of settlement, and (7) the size and nature of an order, noting that “the relative importance of each best execution factor may vary from case to case and best execution of certain types of instructions should be assessed against multiple factors.” The circular also notes that “where a client has given specific instruc-tions which cover one part or aspect of an order, this should not be treated as releasing LCs from their best execution obligations for other parts or aspects of the order.”

The January 2018 circular on best execution emphasizes that “delivering best execution is fundamental to market integrity and protection of investors who rely on LCs to act in their best interests during the execution process.” Regarding the applicability of best execution, the January 2018 report explains that “when LCs enter into agency or back-to-back principal transactions with clients, the obligation to deliver best execution remains with LCs where clients rely on LCs to protect their interests in order execution.” The report also states that orders should be executed in the order that they are received.

After a licensed corporation has effected a transaction on behalf of a client, it is required to promptly confirm the essential features of the transaction with the client (unless otherwise agreed to by the client in writing). Though the details of this requirement are not specified, the SFC has identified as a good practice the preparation of post-trade execution reports that compare the execution outcomes of client orders to benchmarks such as VWAP, to be provided to clients upon request.

The SFC allows third party payments related to the routing or execution of trade orders, but mandates that “firms that exercise investment discretion on behalf of clients” should “only receive goods and services from a broker in relation to directing business to them if they benefit the client, the execution is consistent with the best execution standards, the client has consented in writing to the receipt of the goods and/ or services and disclosure on the firm’s practices for receiving the goods and/ or services is made to the client.” In addition, firms are required “to ensure that where conflicts of interest cannot be prevented, clients are nevertheless treated fairly” and to “disclose any material interest in a transaction that is a conflict of interest to clients.”

The table below highlights the minimum spread applicable for certain stocks that trade on the SEHK. The SFC must approve changes to these tick sizes. ALPs adopt their own tick size rules, often with reference to the tick sizes on exchanges.

In January 2014, the SFC’s Code of Conduct was updated to include new rules governing electronic trading. The new rules apply to firms already registered with or licensed by the SFC that engage in electronic trading, including internet-based trading as well as algorithmic trading.

The Code of Conduct requires that all firms engaged in electronic trading or operating electronic trading systems: (1) control and supervise orders; (2) manage and supervise the ”design, development, deployment and operation of the electronic trading system”; and (3) ensure adequate security, reliability, and capacity, and keep detailed records of all aspects of the trading system including audit logs. It also mandates that all electronic trading firms append risk disclosure statements to their client contracts, which include both generic and (if appropriate) specific disclosures as to the risks of electronic trading. This rule aims to facilitate, among other things, client understanding of the risks of the technologies employed by electronic trading firms.

The Code of Conduct also has rules that are specific to algorithmic trading. Algorithmic traders must (1) “ensure that the algorithmic trading system and trading algorithms it uses or provides to clients… are adequately tested to ensure that they operate as designed” and (2) adopt risk management controls to preserve the integrity of its algorithms and ensure they “operate in the inter-est of the integrity of the market.” In addition, algorithmic trading systems must be tested at least once per year with adequate recordkeeping maintained for at least two years, and risk management controls must be put in place.

In December 2016, the SFC issued a circular to firms engaged in algorithmic trading assessing overall compliance with the 2014 updates to the Code of Conduct. The circular highlighted five areas of compliance deficiency and need for improvement, including: (1) insufficient involvement from management and control functions regarding governance of algorithmic trading; (2) insufficient pre-trade controls; (3) inadequate due diligence of algorithmic trading systems provided by third-party providers; (4) lack of written contingency plans to cope with potential emergencies specific to algorithmic trading; and (5) absence of policies and procedures for testing algorithmic trading systems.

The Code of Conduct does not include rules that apply specifically to HFT, though the general rules applicable to algorithmic trading would also apply to HFT. There are also structural barriers to the use of HFT strategies in Hong Kong equity markets. Stamp duties on the transfer of listed securities, as well as other transaction fees, precede the advent of HFT, but increase the cost of executing HFT strategies. The “tick rule”, which provides that a short sale order for a security cannot be made on the SEHK if it is below the security’s prevailing ask price, is also an impediment to certain HFT strategies. As such, HFT has historically represented a lower share of equity trading in Hong Kong than the United States and Japan (as of 2012, it represented 20 percent of equity trading volume).

In 2016, HKEx introduced a volatility control mechanism (“VCM”) for individual stocks to prevent “extreme price volatility arising from major trading errors and other unusual incidents.” The VCM is applicable to the index constituents of the Hang Seng Index (about fifty companies) and the Hang Seng China Enterprise Index (about eighty securities). These indices account for approximately two-thirds of the total market capitalization of the SEHK. The HKEx does not have a market-wide circuit breaker that halts trading of multiple stocks based on market-wide volatility.

The VCM is applicable to the HKEX’s entire continuous trading session, except for: the first 15 minutes of the morning and afternoon trading sessions; the first 15 minutes after a market reopening; and the last 20 minutes of the afternoon trading session.

The VCM operates as follows: If the trading price of a stock to which the VCM applies changes by more than ±10% relative to the reference price (as defined by the price from 5 minutes earlier), a 5 minute cooling-off period will be triggered. During the cooling-off period, trading is restricted and must be within the trading band range of 10 percent above and below the cooling-off period reference price. Any order that exceeds this price band will be rejected by the exchange. In addition, the system will also cancel the highest-priced buy order in the buying queue (that is, where the buying price is higher than the price limit) or the lowest-priced sell order in the selling queue (that is, where the selling price is lower than the lower price limit). The VCM can be triggered at most once during SEHK’s morning trading session, and at most once during SEHK’s afternoon trading session. Normal trading resumes for the VCM-triggered stock after the cooling-off period. Once a cooling off period is triggered by the VCM, the market is notified of the acti-vated price limits and time of VCM expiration.

With respect to electronic trading, the SFC’s Code of Conduct requires licensed and registered firms to ensure that their electronic trading systems enable them to: “(a) immediately prevent the system from generating and sending orders to the market; and (b) cancel any unexecuted orders that are in the market.” This “kill-switch” functionality empowers firms to immediately halt their trading in the event of uncertainty, error or high volatility. Further, all entities trading on the Hong Kong Futures Automated Trading System (“HKATS,” operated by HKEx) are required to use the HKATS Risk Functions software, which among other things empowers users to execute mass order cancellation.

Regulated markets and multilateral trading facilities

MiFID 2, like MiFID 1, divides European trading venues into two categories for equities trading, namely regulated markets (“RM”) and multilateral trading facilities (“MTF”). The intent of MiFID 2 is to subject similar activities to a similar level of regulation. Therefore, many of the requirements that apply to RMs and MTFs are highly similar as both types of trading venues involve matching trades between third parties on the basis of non-discretionary rules. The key difference between RMs and MTFs is that companies can list on RMs but not MTFs. However, the focus of this report is on secondary market trading, not primary listings. In this section we review the various requirements that apply to trading on RMs and MTFs.

Regulated markets need to be authorized by their competent (regulatory) authority. Authorization as a regulated market is only granted where the competent authority is satisfied that both the market operators, and the system of the regulated market, meet the requirements of the MiFID 2 regime. Authorization may be revoked for, among other things, serious and systematic infringements of the Directive purposes.

MTFs can only be operated by investment firms (who would need to be authorized for that par-ticular investment activity) or market operators (who are also subject to MiFID 2 requirements). MTFs must provide their competent authorities with information on their rules and procedures for trading and in what instances the operation of the system will give rise to conflicts of interest between the MTF, its operators or owners, and its functions.

Trading, access and fees

RMs and MTFs must have transparent and non-discretionary rules for fair and orderly trading, and objective criteria for the efficient execution of orders in the system. The operators of these systems cannot execute orders against proprietary capital or engage in matched principal trading.

RMs and MTFs must provide transparent, fair and non-discriminatory access to market participants, which includes fee structures and co-location services. In relation to fees, trading venues must use objective criteria when determining rebates, incentives and disincentives. Fee structures that contribute to conditions leading to disorderly trading conditions, through encouraging intensive trading and leading potentially to a stress of market infrastructures, are prohibited. With respect to market data fees, trading venues are required to provide market data on a “reasonable commercial basis.” As a result, market data prices must be: (i) based on costs of producing and disseminating such data, including a reasonable margin; (ii) offered on a non-discriminatory basis to all clients; (iii) charged according to the individual end-user’s use; and (iv) available without being bundled with other services.

Different fee structures for the same services can only be established where those fee structures relate to (a) the total volume traded, the number of trades or cumulated trading fees; (b) the services or packages of services provided by the trading venue; (c) the scope or field of use demanded; (d) the provision of liquidity. Trading venues can adjust their fees for cancelled orders according to the length of time for which the order was maintained and to calibrate the fees to each financial instrument to which they apply. They can also impose higher fees for placing an order that is subsequently cancelled than for an order which is executed; trading venues can also impose a higher fee on participants placing a high ratio of cancelled orders to executed orders and on those operating a high-frequency trading technique in order to reflect the additional system use. Volume discounts can be granted, provided that they are based on the total trading volume, the total number of trades or the cumulative trading fees generated by one member, where only the marginal trades executed subsequent to reaching the thresholds are executed at a reduced price. Member States are to ensure, among other things, that RM and MTF fee structures are transparent, fair and non-discriminatory.

ESMA continues to review the issue of market data fees charged by trading venues, observing that further investigation is warranted because, since the implementation of MiFID 2, market data costs have at times increased 400% compared to pre-implementation prices. Market participants claim that trading venues are charging fees far in excess of the costs of producing and distributing market data, and by increasing the number of their fees (by recategorizing fees and charging for supposedly ‘new’ products). Trading venues do not publish their cost of distributing the market data,which makes it difficult to determine whether the fees they charge are excessive. On the other hand, one report prepared by economic consultancy Oxera for the Federation of European Securities Exchanges (FESA) claims that the aggregate market data reve-nues of the members of FESA have only risen in recent years by around 1% per year in real terms. In a July 2019 Consultation Paper, ESMA solicited additional feedback from market participants on the state of market data fees and prospective improvements to market data fee regulation.

Transparency, record keeping and resiliency 

As discussed in more detail in the section of this report dealing with transparency issues, MiFID 2 requires trading venues to make pre- and post-trade information available to the public on a ‘reasonable commercial basis’ and to ‘ensure non-discriminatory access to the information’.

Trading venue operators have detailed record keeping and operating obligations. For example, trading venues need to be able to identify orders generated by algorithmic trading; they also have to have in place effective, systems, procedures and arrangements to ensure that their trading systems are resilient and able to reject orders that exceed pre-determined volume and price thresholds or are clearly erroneous, have sufficient capacity to deal with peak order and message volumes, are able to ensure orderly trading under conditions of severe market stress, are fully tested to ensure such conditions are met, and are subject to effective business continuity arrangements to ensure continuity of their services if there is any failure of their trading systems.

Systematic internalisers

The definition of trading venues under MiFID 2 does not include SIs, but SIs play a significant role in the equity markets. As part of a desire to capture, in regulatory terms, over-the-counter (OTC) trading activity, increase transparency and ensure that the internalization of order flow does not undermine the efficiency of price formation on trading venues, MiFID 2 provided additional objective criteria to help investment firms determine whether they are an SI in relation to a particular financial instrument. Therefore, although the SI regulatory regime already existed under MiFID 1, it assumed greater significance under MiFID 2. 

An SI is an investment firm which, on an organized, frequent systematic and substantial basis, deals on its own account when executing client orders outside a trading venue. ESMA has provided guidance on how to apply the definition. In ESMA’s analysis, SI activity is characterized by risk-facing transactions that impact the profit and loss account of the firm. Investment firms that meet the definition of an SI for a particular financial instrument must notify their regulatory authority, who will in turn notify ESMA.

Under MiFID 2, ‘frequent and systematic basis’ is measured by the size of OTC trades in the finan-cial instrument carried out by the investment firm on their own account when executing client orders; ‘substantial basis’ is measured either by the size of the OTC trading carried out by the investment firm in relation to the total trading of the investment firm in a specific financial instrument, or by the size of the OTC trading carried out by the investment firm in relation to the total trading in the Union in a specific financial instrument. ESMA publishes quarterly data on the total level of trading and number of transactions in financial instruments and classes of instruments, so that investment firms can calculate whether or not they are required to notify their national competent authorities that they are an SI in particular instruments or classes of instrument. A firm will fall under the SI regulatory regime only (i) if it crosses both the pre-set limits for a frequent and systematic basis and for a substantial basis, or (ii) where an investment firm chooses to opt-in under the SI regime.

With respect to SIs, MiFID 2 aims for pre-set OTC trading limits to (i) include OTC trading that materially affect price formation but (ii) exclude smaller OTC trading for which the cost compliance with SI requirements is disproportionate in light of the minimal effect on price formation.

The best execution obligation, described in detail later in this report, requires that investment firms attempt to obtain the best possible results for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order. For orders at or below standard market size, SIs are generally required to execute client orders at the SI’s quoted prices at the time of reception of the orders. However, when “justified,” they may execute those orders at a better price provided that the price falls within a public range close to prevailing market conditions. ESMA considers that price improvements would only be “justified” where they are meaningful and reflect the minimum tick size applicable to the same financial instrument traded on a trading venue. Otherwise, according to ESMA, marginal price improvements on quoted prices would challenge the efficient valuation of equity instruments without bringing any real benefits to investors. Conversely, for orders above standard market size, SIs can offer sub-tick price improvement.

SIs are allowed to withdraw their quotes under exceptional market circumstances (such as where there are trading halts or suspensions from trading). In order to limit their counterparty exposure, SIs are also allowed to limit in a non-discriminatory way the number of transactions from the same client which they undertake to enter at the published conditions, or to limit the total number of transactions from different clients at the same time where the number and/or volume of the orders exceeds the norm.

MiFID 2 imposes requirements for (a) pre-trade transparency and (b) post-trade transparency and regulatory reporting. With respect to post-trade information, MiFID 2 requires both: (1) certain post-trade transparency to the public (trade reporting) and (2) post-trade disclosures to regulators (transaction reporting).

Pre-trade transparency is to be provided on a continuous basis, throughout normal trading hours. Post-trade trade reporting to the public must be done in real time to support the accurate formation of prices. Transaction reporting to regulators must be completed no later than the close of business on the business day following the execution day. Regulators collect transaction reports in order to monitor markets and supervise for manipulation of financial markets or other market abuses.

Pre-trade transparency

In terms of pre-trade transparency, trading venues (i.e. RMs, MTFs) must make public current bid and offer prices, and the depth of trading interests (including actionable indications of interest) at those prices, which are advertised through their systems for shares and other equity-like instruments. Those transparency requirements are calibrated for different types of financial instruments (taking into account the interests of investors and issuers, and market liquidity) and different trading systems (taking account of transaction size, and other relevant criteria). The information is to be made available to the public on a reasonable commercial basis, with non-discriminatory access, and disaggregated from other services. The information is to be free of charge 15 minutes after publication. However, due to continuing low levels of compliance, ESMA issued guidance in July 2019 to discourage practices that were inconsistent with the obligation to make information available free of charge (including access restrictions, the use formatting that is not machine-readable, and deleting data shortly after publication).

Likewise, for orders at or below the standard market size, SIs need to make public and easily accessible on a continuous basis during normal trading hours firm two-way quotes in respect of shares and equity-like instruments for which (i) they are SIs and (ii) there is a liquid market. “Standard market size” is the average value of transactions for each financial instrument over the preceding year in the EU, subject to certain adjustments. Any restrictions they impose on access to that information could be based on commercial policy (distinguishing for example between different categories of clients) but needs to be done in an objective non-discriminatory manner. Where there is no liquid market, SIs are only required to disclose quotes to their clients upon request. Quotes are to be made public in a manner which is easily accessible to other market participants on a reasonable commercial basis.

National competent authorities have discretion to waive the obligation for trading venues to dis-close the above pre-trade information. There are four types of such waivers (all discussed in further detail in the section on ‘Dark v lit trading’): (1) the reference price waiver; (2) the negotiated trade waiver; (3) the large in scale waiver; and (4) the order management facility. Waivers are seen as ensuring an appropriate balance between transparency and liquidity in equities markets. Both the ESMA and various national regulators have issued guidance on waiver applications.

Pre-trade and post-trade transparency data is to be made available by the trading venue and SIs separately. ESMA has specified the level of disaggregation of that data (data is to be disaggregated by asset class, by country of issue, by the currency in which a financial instrument is traded, and according to whether data comes from scheduled daily auctions or from continuous trading).

Post-trade disclosure to regulators: transaction reporting

Investment firms that execute transactions in financial instruments need to report to regulators the complete and accurate details of such transaction no later than the first business day following execution, with each report needing to include 65 data fields (increased from 23 fields under MiFID 1). These transaction reports are collected in order to prevent the manipulation of financial markets, or other market abuse.

The reports have to identify both the client and the trader or algorithm responsible for the invest-ment decision and execution, so investment firms that receive and transmit orders have to include such details in any orders they transmit, unless they wish to report such orders themselves.

The reports essentially cover every stage of the trade, from the portfolio investment decision, initial indication of interest and order management right through to execution. One major change that MiFID 2 has brought is the mandatory introduction of Legal Entity Identifiers (LEIs) – unique 20-digit alpha-numeric codes identifying legal entities or structures trading on EU markets, which are included in a global data system and enable every legal entity that is a party to a relevant financial transaction to be identified, no matter where it is located. All entities trading with European counterparties across all asset classes must obtain LEIs. There was an extension of the initial deadline for compliance, but the grace period for all legal entities involved in executing trades to obtain LEIs ended on July 2, 2018.

Under MiFID I, transaction reporting applied only to shares trading on an RM. The requirements have been extended to all trading venues and to all financial instruments that are admitted to trading on a trading venue, even if trades take place outside the trading venue. Transaction reporting requirements are calibrated for different types of instruments and different types of trading.

Transaction reporting can be made by the investment firm, an Approved Reporting Mechanism (“ARM”) acting on its behalf, or by the trading venue through whose system the transaction was completed. Alternatively, reporting to a trade repository under EMIR satisfies the obligation. The responsibility for the accuracy, completeness and timely submission of the transaction reports lies with the investment firms (except where the failure is attributable to the ARM or the trading venue which is submitting the report, but even then investment firms must take reasonable steps to verify those reports).

Post-trade transparency to the public: trade reporting

The post-trade public transparency obligation is often referred to as ‘trade reporting’. It applies to trading venues and investment firms trading outside the rules of a trading venue (including SIs). The purpose of trade reporting is to support efficient price formation.

The obligation requires that trading venues and investment firms make public the price, volume and time of the executed transactions in shares (and other equity-like instruments) as close to real time as is technically possible. The information is to be made public directly (by trading venues) and through an Approved Publication Arrangement (“APA”) (for SIs and other investment firms). The information is to be made available to the public on a reasonable commercial basis, with non-discriminatory access. It also must be offered free of charge 15 minutes after publication, but compliance with the latter obligation has been limited and inconsistent.

Where a transaction between two investment firms is concluded outside the rules of a trading venue, either on own account or on behalf of clients, only the selling firm shall make the disclosure (unless only one of them is a systemic internaliser and that firm is a buyer, in which case the buyer will make the disclosure).

Trade reporting requirements are subject to the possibility of a deferral of disclosure for transactions that are large in scale compared to normal market size (block trades), if authorized to do so by the national competent authority. The existence of deferred trade-publication arrangements is to be clearly disclosed to market participants and the public.

Data reporting service providers

Data reporting service providers must be authorized under MiFID 2 and are thereafter subject to ongoing compliance duties in particular with regard to the existence and management of any conflicts of interest. There are three different kinds of data providers (“DRSP”) under MiFID 2, all independent entities, which must be authorized by the relevant the National Competent Authority in each Member State (that authorization then allows them to provide services throughout the EU). The three types of DRSPs are: Approved Reporting Mechanisms (“ARM”), Approved Publi-cation Arrangements (“APA”), and Consolidated Tape Providers (“CTP”).

ARMs enable investment firms to meet their transaction reporting obligations by reporting details of transactions to competent authorities (in the UK, for example, that is the FCA) or to ESMA, no later than the close of the working day following the day on which the transaction took place. As set out above, transaction reports are collected in order to prevent the manipulation of financial markets or other market abuse.

APAs enable investment firms to meet their trade reporting obligations by making public the relevant details of the trades as close to real time as is technically possible. The information must be published on a reasonable commercial basis, and after 15 minutes without charge. The publication of this information is part of the MiFID 2 transparency regime intended to support the accurate formation of prices. However, the market has not yet achieved widespread compliance.

CTPs collect trade reports for financial instruments from trading venues and APAs, and they then consolidate them into a continuous electronic live data stream providing price and volume data for each financial instrument. The data stream is to be made available to the public on a reasonable commercial basis.

In the UK, for example, there are currently six DRSPs authorized,  two as only APAs and four as both APAs and ARMs.

No CTPs have emerged in Europe following the implementation of MiFID 2. While MiFID 2 sets out the legal framework for operating voluntary consolidated tapes, it anticipates rather than directly mandates their creation. However, it also sets forth a mechanism to review and revisit the framework to ensure CTPs do eventually emerge. Although an EU-wide CTP would improve efficiency by consolidating all post-trade information into one place and format, ESMA has found that there are few commercial rewards for operating a consolidated tape, the CTP regulatory framework is too restrictive, and CTP’s would face stiff competition from unregulated entities. As a result, it is currently uneconomical for a commercial organization to undertake the required data processing and cleaning. In its July 2019 report on trading costs and market data, ESMA concluded that the successful establishment of a pan-European CTP would require, among other things: (i) the mandatory reporting of post-trade data by trading venues and APAs; and (ii) the mandatory of consolidated market data by investment firms.

Dark trading refers to trading in equities without pre-trade transparency, where the price and volume of orders are hidden and anonymous. Dark trading in the EU can take place across different execution venues, including Regulated Markets, MTFs and SIs. Execution venues can allow for both lit and dark trading. Dark trading generally involves matching trades through a reference price system. Typically, the reference price for dark trading is based on the best bid and offer on the primary Regulated Market, known as the Primary Best Bid and Offer (PBBO) (for shares in the UK, this is the London Stock Exchange). Alternatively, reference prices can also incorporate the best bid and offer prices at other lit venues, with this typically labelled as the European Best Bid and Offer (EBBO). As can be seen from this description, the process of determining reference price may differ between execution venues, leading potentially to differences in execution prices.

Pre-trade transparency waivers

The key regulatory issue relevant to dark trading is the requirement for pre-trade transparency for trading in stocks. In 2007, the original MiFID introduced the concept of pre-trade transparency waivers. This meant that, in situations where waivers applied, bid and offer prices did not need to be published by the trading venue before an order was executed (in other words dark trading could take place). Dark trading existed prior to MiFID I through over the counter trading or special hidden order types on exchanges, but following the introduction of the waivers, dark trading volumes increased.

MiFID 2 also provides for pre-trade transparency waivers, although with some changes in their definitions. The four waivers under MiFID 2 are: the reference price waiver, the negotiated trade waiver, the large in scale waiver, and the order management facility waiver.

As previously described, the “reference price waiver” allows for trades to take place without the public display of price or size, so long as the price is determined with reference to the publicly displayed price for that stock on the primary listing exchange or the most relevant market in terms of liquidity. The scope of this waiver has been narrowed under MiFID 2. Reference price trades are now only allowed at the midpoint between the best bid and offer, while previously they were allowed at the bid and offer. If a trade is taking place outside of trading hours and the midpoint price is not available, the opening or closing price of the trading session can be used.

The “negotiated trade waiver” allows for trades to take place without the public display of price or size, so long as members or participants of a trading venue privately negotiate the terms of a transaction, which is then reported under the rules of the trading venue. There are three types of negotiated trades that qualify for the waiver. First, trades that are made within the current volume weighted spread reflected on the order book, or the quotes of the market makers of the trading venue operating that system. Second, trades in illiquid shares dealt within a percentage of a suitable reference price (the percentage and the reference price being set in advance by the system operator). Third, trades that are subject to conditions other than the current market price.

The “large in scale waiver,” or “LIS waiver,” allows for trades to take place without the public display of price or size, so long as orders are sufficiently large in size compared with normal market size. The minimum size thresholds are set with reference to average daily turnover for the financial instrument in question.

The “order management facility waiver” allows for trades to take place without the public display of price or size, so long as orders have been held in an order management facility of the trading venue pending disclosure. Order management facilities enable investment firms to break up large client orders into smaller orders for execution on a trading venue. Doing so is intended to reduce the price impact of these large orders.

Double volume caps

MiFID 2 introduced the double volume cap mechanism (“DVC”) to limit the amount of dark trading in equities allowed under two of the waivers, namely the reference price waiver and the first of the three types of the negotiated trade waiver. MiFID 2 also changed the size thresholds for the use of the LIS waiver, lowering them for low volume stocks, and increasing them for the most active stocks in the market. The double volume caps only apply to transactions executed on multilateral trading venues (i.e. RMs, MTFs) but not to OTC or SI transactions.

The first DVC cap applies to the total amount of dark trading per venue. It limits the percentage of trading in a financial instrument carried out on any individual trading venue under the reference price waiver and the first negotiated price waiver to 4% of the total volume traded in that instrument on all trading venues in the EU over the previous 12 months.

The second cap applies to overall dark trading. It limits the percentage of dark trading in a financial instrument carried out under the reference waiver and the first negotiated price waiver to 8% of the total volume traded in that financial instrument on all trading venues in the EU over the pre-vious 12 months.

If a trading venue reaches the first cap, then the use of the two waivers in question on that venue for that instrument is suspended for six months. If the EU wide limit for the instrument is reached (the second cap), then the use of both waivers for that instrument is suspended for all trading venues for six months. The trading of the respective stock is suspended by the national competent authority within two working days for either the respective trading venue, or all trading venues, depending on which cap has been triggered, based on ESMA’s previous month’s published calculations. ESMA performs its calculations over a twelve-month rolling period and publishes the data on its website, in the Double Volume Cap Register.

The DVC does not apply to a share for which there is no liquid market. There is no liquid market if: i) the free float is less than EUR 100 million for shares admitted to trading on a regulated market and less than EUR 200 million for shares that are only traded on MTFs; ii) the average daily number of transactions in the share is less than 250; iii) the average daily turnover for the share is less than EUR 1 million.

Impact of double volume caps

By June 2018, the DVC resulted in the suspension of dark trading of more than 900 financial instruments, mostly shares. As of September 2018, the application of the DVC resulted in the suspension of dark trading for more than 1,200 instruments, again mainly equities.

The first set of restrictions expired in September 2018. In its first detailed report on the impact of the rules (in February 2019), ESMA said that, for the equities banned by the DVC mechanism in March 2018 and for which the ban ended in November 2018, the volume of trading executed in dark trading fell to less than 1 percent of the total traded in August 2018 (from 7 percent in January 2018). The report expressed a view that conditions in lit exchanges improved while the caps were in place, with the size of bid-ask spreads tightening, and breadth and depth improving, but worsened when measured by the turnover ratio and average trade size.

When executing client orders, investment firms must choose among multiple execution venues and the best execution obligation informs their routing decisions.

Article 27 of the MiFID 2 Directive introduced a new requirement for investment firms to take ‘all sufficient steps’ (not just ‘all reasonable steps’) to obtain, when executing orders, the best possible results for their clients, taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order (or “best execution”). ESMA has specifically stated that ‘the requirement for ‘sufficient’ steps sets a higher bar for compliance than ‘reasonable’ steps.

In addition, Article 23 of the MiFIR Directive requires investment firms to ensure that the trades that they undertake are in shares admitted to trading on a regulated market or traded on a trading venue take place on a regulated market, multilateral trading facility, systematic internaliser, or third-country trading venue assessed as equivalent by the EU. The European Commission has issued equivalence determinations with respect to trading venues in the United States, Hong Kong, and Switzerland.

In the context of best execution, one can distinguish between the actions and processes involved in achieving best execution, on the one hand, and the reports and records that need to be available to evidence that execution, on the other. For clarity, these execution-related reports are different from and additional to the transaction reports to regulators discussed above.

Actions and processes

Investment firms have to ensure that the intended outcomes for their clients can be achieved successfully on an ongoing basis. This does not mean that the firm must be able to obtain the best possible price for its clients on every single occasion. It means that the firms will need to have processes in place, to verify that their order execution process is consistent with their best execution obligation. If any deficiencies are detected, they are required to take all appropriate remedial actions to ensure that they are taking ‘all sufficient steps’ to achieve the best possible results for their clients.

When executing client orders, investment firms are to take into account a number of factors (characterization of the client, characteristics of the order, of the financial instrument, of the execution venue). Where an investment firm executes an order on behalf of a retail client, the best possible result is determined in terms of the total consideration (representing the price and the costs relating to execution). Investment firms cannot receive any remuneration, discount or non-monetary benefit for routing client orders to a particular trading or execution venue, as also addressed in the payment for order flow section of the report.

When it comes to investment firms that do not directly execute on an execution venue, but rather place or transmit client orders for onward execution, they are also subject to the ‘best execution’ obligation. They need to provide disclosures in relation to the entities or intermediaries to which they pass an order in the chain of execution.

Reports and recording

The detailed reporting rules are set out in RTS 27 (data to be published by execution venues) and RTS 28 (information to be published by investment firms, on the identity of execution venues and on the quality of execution). These reports are different from the transaction reporting and trade reporting discussed in the previous section of this report. RTS 27 and 28 reports are meant to provide clients with an ongoing view of the execution they are receiving in the marketplace.

RTS 27 requires that execution venues make available to the public, without any charges, detailed data relating to the quality of execution of transactions on that venue. The RTS 27 reporting requirements cover all transactions in financial instruments, including those that are subject to the pre-trade transparency waivers. The data is to include the details of the price, costs, speed and likelihood of execution for individual financial instruments490 and is to be published quarterly, no later than three months after the end of each quarter.

RTS 28 reports summarize execution quality achieved by investment firms. RTS 28 specifies both the format and the content of the information to be published by investment firms on an annual basis in relation to client orders executed on trading venues, SIs, market makers or other liquidity providers or entities that perform a similar function in a third country. The reports are to be made public on or before the 30th of April following the end of the period to which the report relates, and are to remain available in the public domain for a minimum period of two years.

In terms of their content, the RTS 28 reports by investment firms are to identify the top five execution venues or firms (brokers where they have sent client orders), in terms of trading volumes for all executed client orders per class of financial instrument (in different formats for retail and for professional clients). The reports should include a list of qualitative and quantitative factors used to select the execution venues. They are also to provide a summary of the analysis and conclusions the investments firms draw from their detailed monitoring of the quality of execution they obtained on the execution venues they used, again in relation to each class of financial instrument. The reports are to include matters such as how the price, costs, speed and likelihood of execution are factored in the overall assessment of execution quality achieved; whether there are close connections to venues, conflicts of interest or shared ownership of venues has influenced execution quality; whether (non-) monetary benefits have been received; whether any changes occurred regarding the execution venues listed in the best execution policy, and whether execution quality differs if confronted with retail or professional clients.

When firms provide both order execution and the transmission of orders to a third party for execution, they need to provide two separate reports in relation to those services. Specifically, they must provide (1) the top five execution venues at which they execute orders and (2) the top five entities (brokers) to which they routed client orders in the relevant period.

As far as record keeping is concerned, MiFID 2 imposes the following record keeping and documentation obligations on investment firms: (1) the requirement to record all services, activities and transactions; and (2) the requirement to provide clients with reports on all services provided.

Payment for order flow

Payment for order flow (“PFOF”) occurs when an investment firm that routes client orders receives a fee from the counterparty with which the trade is then executed (typically a market maker or other liquidity provider). Under MiFID 2, these payments are viewed as creating a conflict of interest between the investment firm and its client, by incentivizing the firm to route its client orders to counterparties willing to pay the highest fee. 

Specifically, Article 27(2) of the MiFID 2 Directive states: ‘An investment firm shall not receive any remuneration, discount or non-monetary benefit for routing client orders to a particular trading venue or execution venue, which would infringe the requirements on conflicts of interest or in-ducements…’. The EU rules on conflict of interest or inducements are such that Article 27 has been construed as prohibiting payments for order flow in the EU. However, because the prohibition must be implemented by respective member states, there is potential for regulatory divergence.

Maker/taker arrangements

However, trading venues, can provide market makers with incentives to provide liquidity to the trading venue. MiFID 2 provides that trading venues need to have written agreements in place with any investment firms pursuing a market making strategy on their market, including details of any incentives in terms of rebates, or otherwise offered by them to the investment firm in return for providing liquidity on a regular and predictable basis, or any other rights accruing to such a firm. Trading venues are obliged to inform their national competent authority about the content of those agreements.

ESMA has clarified that ‘rebates’ in this context includes negative fees, direct payments, refunds or discounts on fees due from the provider of liquidity to the trading venue. ‘Maker/taker arrangements’, in which financial incentives are provided to market participants to conclude trades by posting passive orders, are permitted both in relation to investment firms required to enter into market making arrangements, and in relation to other market makers provided they are subject to the appropriate market making obligations. Article 17(4) requires that investment firms engaged in algorithmic trading enter into a market making arrangement when they: deal on their own account, post firm simultaneous two-way quotes of comparable size and at comparative prices relating to one or more financial instruments on a single trading venue or across different trading venues, with the result of providing liquidity on a regular and frequent basis to the overall market.

MiFID 2 requires a share’s minimum tick size to be calibrated in terms of liquidity measured by the average daily number of transactions executed on the most relevant market. The regime applies equally, regardless of the currency of the financial instrument, as it determines only the minimum difference between the two price levels of orders sent in relation to a financial instrument in the order book.

The requirement applies to both orders and quotes. Originally, SIs did not need to comply with the tick size regime, but the regulatory standards were modified to extend the tick size regime to SIs for trades at or below standard market size.

MiFID 2 defines “algorithmic trading” as trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention.

MiFID 2 imposes organizational requirements on investment firms engaged in algorithmic trading, including requirements to put in place systems and risk controls of algorithms and keep sequenced records with respect to its trading activity. Firms must have both pre and post trade controls to monitor, identify and reduce trading risks across algorithmic trading activity. The aim of these requirements is to ensure the resilience of trading systems, to avoid the transmission of erroneous orders and to provide supervisors with information on the activities of algorithmic trading. Algorithmic traders that use market making strategies must enter into market making agreements with trading venues on which they operate, to ensure that they provide liquidity on a regular and predictable basis.

An investment firm engaging in algorithmic trading or providing direct electronic access must notify its Member State competent authority and the Member State competent authority of any trading venue of which it is a member. Its competent authority may require it to provide, on a regular or ad-hoc basis, (a) a description of the nature of its strategies, (b) details of the trading parameters or limits to which the system is subject, (c) a description of the key compliance and risk controls that it has in place and (d) information about the testing of its systems. The competent authority of the investment firm’s home jurisdiction is also required to communicate that information to the competent authority of the trading venue upon request.

Trading venues enabling or allowing algorithmic trading through their systems are also subject to various obligations, including certain organizational requirements, and requirements affecting capacity and resilience. Trading venues are required to provide testing platforms to ensure that algorithms can deal with stressed market conditions. Trading venues must also have in place certain pre-trade controls adopted for each instrument traded on them (price collars, maximum order value and maximum order volume) and can have such post-trade controls as they deem appropriate on the basis of their risk assessment. Trading venues must set limits on the number of order messages that a market participant can send relative to the number of transactions they undertake (the participant’s order-to-trade-ratio, or “OTR”). In addition, to enable retrospective reconstruction of trading activity by regulators, investment firms and trading venues must syn-chronize their clocks.

MiFID 2 defines “high frequency trading” or “HFT” as a subset of algorithmic trading characterized by: (a) infrastructure intended to minimize network and other types of latencies, including at least one of the these facilities for algorithmic order entry: co-location, proximity hosting or high-speed direct electronic access; (b) system-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders; and (c) high intraday message rates which constitute orders, quotes or cancellations.

HFT firms are subject to the obligations imposed on algorithmic trading firms generally and also must comply with further obligations. For example, HFT firms must store time-sequenced records of their algorithmic trading systems and trading algorithms for at least five years. Trading activity must be time-stamped with 100-microsecond accuracy. Further, ESMA has taken the position that high frequency traders should ‘immediately’ seek authorization as investment firms.

A salient characteristic of certain HFT strategies, including the market making and arbitrage activities described in Section 1f, is the submission, revision and or cancellation of a large number of orders within a short time period. The high number of order messages has given rise to concerns about the ability of IT systems at trading venues to handle these significant volumes. As noted earlier, MiFID 2 mandates that trading venues set limits on market participants’ OTR; MiFID 2 also allows, but does not require, OTR fees. Several European jurisdictions had already introduced OTR fees prior to MiFID 2. Italy was among the first jurisdictions to assess an OTR fee: Borsa Italiana, Italy’s main stock exchange, charges a fee-per-order that increases on a sliding scale based on a trader’s OTR. France implemented OTR fees as part of a legislative package that also included a financial transactions tax on certain stock transactions. A fee equal to 0.01% of the notional amount of modified or cancelled orders is imposed on financial intermediaries established in France whose OTR exceeds five. Notably, the OTR fee is directed only at HFT activities that are thought to be potentially harmful. Accordingly, activities pertaining to market making, smart order routing, and automated execution of large orders are exempt from the fee. Norway has also introduced OTR fees on the Oslo Stock Exchange; a fee of 0.05 Norwegian krone (NOK) per order is levied on traders with OTR higher than 70 to 1. The ratio is calculated on a monthly basis, and like the French OTR fee, is targeted only at activities that are perceived to be detrimental to market quality: orders that stay in the market for longer than a second, or that improve price or volume are not counted towards the OTR.

The separate Market Abuse Regulation (MAR) targets market manipulation. Though the MAR is targeted at market manipulation rather than algorithmic trading, it includes provisions that specifically mention algorithmic trading and HFT: it explicitly prohibits sending orders, including by means of algorithmic trading and HFT strategies, that would disrupt or delay the functioning of trading venues’ servers, make it difficult to identify genuine orders, or create or likely create misleading signals about the supply and demand of a financial product. Indicators of manipulative orders include the extent to which (1) trader’s orders represent a significant proportion of trading activity, (2) orders are concentrated in a short time-span, and (3) orders change the order book, as well as (4) position reversals and (5) whether orders are sent at a specific time in the trading session. Investment firms or trading venues that detect suspicious trading activity are required to report to their regulator.

In the EU, the primary volatility controls include measures on the provision of continuing liquidity, on circuit breakers and trading halts, and on trading venue capacity generally.

MiFID 2 requires trading venues to seek to ensure that they have in place a sufficient number of market-making agreements with investment firms to achieve liquidity, appropriate for the nature and the scale of their trading. Trading venues must also communicate the existence of stressed market conditions to all market makers. Exceptional circumstances, when the obligation to provide liquidity does not apply, are to be defined exhaustively. 

Further, trading venues are to have in place effective systems, procedures and arrangements to ensure that their trading systems have sufficient capacity to deal with peak order and message volumes, are able to ensure orderly trading under conditions of severe market stress, are fully tested to ensure such conditions are met, and are subject to effective business continuity arrangements to ensure continuity of their services if there is any failure of their trading systems. They should have effective systems, procedures and arrangements to reject orders that exceed pre-determined volume and price thresholds or are clearly erroneous.

Trading venue obligations include the need to have mechanisms in place to temporarily halt or constrain trading if there is a significant price movement in a financial instrument on that trading venue or a related trading venue during a short period and, in exceptional cases, to be able to cancel, vary or correct any transaction (a circuit breaker). The trading venue with the highest turnover in a financial instrument in the EU has to have necessary systems and procedures in place to notify its competent authority that its circuit breaker has been triggered and its trading halts applied, so that a market-wide response could be put in place, if appropriate.

ESMA has issued guidelines on the calibration of circuit breakers and publication of trading halts under MiFID 2. The calibration is to be done according to a pre-defined, statistically supported methodology, taking into account factors such as the nature of the financial instrument, the liquidity profile and the quotation level of the financial instrument, the volatility profile of the financial instrument, the order imbalance (when manual re-calibration may be required), and static and dynamic reference prices (unless the trading venue can demonstrate that only one of those categories is sufficient).

MiFID 2 requires investment firms engaged in algorithmic trading to have emergency “kill functionality,” allowing them to cancel all of their unexecuted orders with immediate effect, where that becomes necessary.

Trading venues must have systems and procedures in place to ensure that algorithmic trading cannot create or contribute to disorderly trading conditions. This includes an obligation to calculate the ratio of unexecuted orders to transactions effectively incurred by their members or participants at the level of each financial instrument traded on them, in order to ensure effectively that the ratio does not lead to excessive volatility in that instrument.

There are four financial instruments markets (stock exchanges) in Japan: the Japan Exchange Group (“JPX”), formed from the combination of the Tokyo and Osaka exchanges, and the Nagoya, Sapporo, and Fukuoka exchanges. Japanese stock exchanges were historically membership organizations consisting of securities companies. However, under a 2000 amendment to the FIEA, they were authorized to change their status to joint stock companies—the JPX (parent company of the Tokyo Stock Exchange (“TSE”)) and the Nagoya Stock Exchange have already done so. The JPX is listed on the TSE.

The vast majority of companies listed on Japan’s stock exchanges are on the TSE: as of April 2019, there were 3,665 companies listed on the TSE, compared to 292 for the Nagoya Stock Exchange (of which only 66 were listed exclusively), 109 for the Fukuoka Stock Exchange (26 exclusive listings), and 57 for the Sapporo Securities Exchange (16 exclusive listings).

In terms of equity market capitalization, the TSE is the third largest exchange in the world after the U.S. New York Stock Exchange and NASDAQ. In terms of value of trading, the TSE ranks sixth. As of February 2019, the total market capitalization of the shares listed on the TSE was JPY 629 trillion and the value of shares traded on the TSE in that month was JPY 54 trillion.

As of 2017, TSE has 93 trading participants, all of which are registered FIBOs. Japanese securities firms include two major independent securities groups designated as Domestic Systemically Important Banks (D-SIBs) as well as the securities subsidiaries of the Japanese megabanks that are G-SIBs. Foreign-owned FIBOs that are part of global G-SIB banking groups also have a significant presence in Japan, accounting for more than half of the trading value at the TSE as of 2017. The clients of FIBOs are primarily institutional investors, and institutional order flow accounts for between 70 to 80% of trading volume in the Japanese stock market as of 2015.

A 1998 amendment to the FIEA enabled competition between other trading venues and Japanese stock exchanges by: (1) abolishing the “concentration rule” that required FIBOs to route orders only to stock exchanges; (2) introducing a regulatory framework for “proprietary trading systems” (“PTSs”) similar to the “alternative trading system” (in the United States) and “multilateral trading facility” (in the European Union) frameworks; and (3) putting in place a set of rules for trading of unlisted stocks.

Alternative trading venues in Japan include regulated, “lit” PTS and unregulated, “dark” venues (for both order matching and internalization) operated by FIBOs. In February 2019, approximately 9.8 percent of trading of listed stocks occurred off-exchange (including PTS and unregu-lated dark venues), with approximately 60 percent of off-exchange trading (or 5.9 percent of all trading) occurring on PTS.

Stock Exchanges

Financial instruments exchanges operate financial instruments markets (stock exchanges), managing and supervising the trading process and the business conduct of securities companies. The FIEA requires financial instruments markets to be licensed by the Minister of Financial Services (“MoFS”) on behalf of the Prime Minister, based on the recommendation of the FSA, which reviews applications for compliance with legal requirements. Financial instruments exchanges, which operate financial instruments markets, must have capital of at least JPY1 billion.

Financial instruments exchanges are overseen on an ongoing basis by the FSA and the SESC. Authorization from the FSA is required for any material change to the articles of incorporation, operational rules or brokerage contract rules. The FSA also must be notified if changes are to be made to other rules, when securities or financial instruments are listed or when trading suspensions are imposed or lifted.

Financial instruments exchanges must ensure that securities and derivatives markets are fair and protect investors by conducting regulatory, supervisory and disciplinary activities with respect to their members. Financial instruments exchanges can exercise self-regulatory authority themselves or delegate this authority to a separate SRO. For example, the TSE and Osaka Exchange have delegated their self-regulatory services to Japan Exchange Regulation (“JPX-R”), a subsidiary of JPX. The other exchanges (Nagoya, Fukuoka, and Sapporo) undertake their own self-regulatory services. SROs must keep records and prepare reports as required by regulation.

JPX-R determines disciplinary actions against trading participants for violations of laws and regulations. Possible actions include fines, censure, trading suspension, and limiting or canceling trading qualifications. The disciplinary actions are determined after a hearing with the trading participant and consultation with the disciplinary committee, which is an advisory body to the JPX-R board. The TSE and Osaka Exchange take action based on the recommendations of JPX-R. The disciplinary actions are published, and several actions have been taken over the past years.

Access to exchanges

In order to trade on an exchange, a FIBO must first pass a qualification examination to be desig-nated a trading participant. The operational rules of an exchange must contain detailed regulations relating to trading participants. Financial instruments exchanges are prohibited from un-just, discriminatory treatment of a member. Fairness of access is examined as part of the FSA’s review of a financial instruments exchange’s license application and any amendment after licensing is also reviewed for this purpose. Accordingly, before providing co-location facilities, both the TSE and Osaka Exchange discussed fair access with the FSA.

JPX-R, the SRO responsible for conducting regulatory, supervisory and disciplinary activities for the TSE and Osaka Exchange, organizes qualification examinations for trading participants and conducts inspections of them. The admission process for trading participants on the TSE requires that the JPX-R conduct examinations based on documents, hearings, onsite inspections of internal management systems at the applicant’s headquarters and branch offices, and interviews with senior executives. The qualification criteria for the TSE include: (1) financial criteria (capital of at least JPY 300 million, net assets of at least JPY 500 million and an amount greater than capital, and capital adequacy ratio exceeding 200 percent); and (2) operational criteria (sound management structure, order placement, execution, and clearing and settlement systems that contribute to fair and smooth trading, and appropriate internal management system (compliance with laws and regulations, risk management, development of rules, etc.)).

Only approved trading participants are connected to a financial instruments exchange’s trading systems and may conduct sales and purchases of securities. However, sponsored client access is permitted, so long as trading participants have appropriate order management systems for their clients. In practice, trading participants establish order limits per client based on ratings and financial standing. The robustness of such “filters” is reviewed ex-post via on-site inspections by the JPX-R, financial instruments exchanges and/or the FSA.

Trading fees

Financial instruments exchanges are required to obtain approval from the FSA for changes to their fees or fee models. Exchanges are required to perform benchmarking analysis and/or impact analysis, and the FSA must determine whether the structure of the model or the fee change is fair or unduly discriminatory. The FSA evaluates the reasonableness of fee models and trading fees by considering service provided vs. fees charged, operational cost, value added, comparable fees of other trading venues and competition factors.

Trading participants on the TSE are required to pay several different fees: (1) a basic monthly fee assessed to every trading participant; (2) fees for traded stock, based on the value of the trade; (3) fees based on the number of accesses per month (each entry, change and cancellation of an order is considered an “access” for these purposes); and (4) trading system usage facility fees based on the number of servers and/or terminals used.

Proprietary trading systems

Alternative trading venues in Japan include regulated, lit proprietary trading systems and unregulated, dark venues (for both order matching and internalization) operated by FIBOs. A PTS is an alternative trading platform where matching of trading orders from various FIBOs takes place in an organized fashion. Operating a PTS requires both generic registration as a Type I Financial Instruments Business and a separate authorization for operating the PTS. The authorization is subject to having at least JPY 300 million of capital (higher than the JPY 50 million required for broker-dealers, but lower than the JPY 1 billion of capital required for financial instruments exchanges).

PTS must be authorized by the FSA. The applicant’s price formation method, settlement method, business plan and business methods must ensure that public interest and investor protection are maintained. FSA’s Supervisory Guidelines include further authorization criteria, such as internal controls, disclosure of price information, reporting of transaction volume, etc.

A PTS operator is also required to provide fair market access, which is determined as part of the authorization process as well as ongoing monitoring of subsequent amendments to relevant rules. PTS are not required to disclose trading fees, but they generally do so in practice.

Bids and offers made on a PTS, as well as transactions completed in listed securities (and prices), must be disclosed to members and the public. This information must also be provided to the FSA. In practice, information on PTS is consolidated by the Japan Securities Dealers Association (“JSDA”) and disclosed via the JSDA website. Accordingly, PTSs are lit venues: they have well defined market structure and market participants with price formation taking place in the visible order book.

The main differences between financial instruments markets (stock exchanges) and PTS are as follows:

(1) approval (operation of an exchange requires a license, whereas operation of a PTS only requires authorization);

(2) capital requirements (financial instruments exchanges are required to have capitalization of JPY 1 billion, compared to JPY 300 million for PTS);

(3) financial instruments markets have restrictions on holding of voting rights constituting 20 percent or more;

(4) financial instruments exchanges exercise (or delegate) self-regulatory functions such as examination of member compliance, surveillance of the members’ transactions, screening of membership qualifications, and sanctions against members who breach rules; and

(5) PTS that reach 10% market share must be licensed to become a financial instruments market.

Unregistered “dark pools”

FIBOs are allowed, without authorization as a PTS operator, to operate “dark” trading systems whereby customer orders are electronically matched or internalized and then reported to the off-auction trading hours trading network offered by a financial instruments exchange. These dark pools began to appear in Japan around 2005 and have since become a standard product offering for major international brokerage houses as well as some of the large domestic securities firms. The FSA currently plans to introduce new regulation enhancing the transparency of dark pools.

Over-the-counter market

Shares of companies that are not listed on a stock exchange or registered with the over-the-counter (“OTC”) market are traded over the counters of securities companies; these transactions are reported to the JSDA, but the volume of trading in these issues is limited.

Financial instruments exchanges are required to provide pre-trade transparency, because they must publicly display information on bids and offers. Separately, when entering bids or offers, trading participants must disclose to the exchange whether the transaction is as principal or agent, a short or margin sale, but this information need not be publicized more broadly.

Financial instruments exchanges also are legally required to provide post-trade transparency: post-trade information must be publicly displayed immediately after a trade occurs. Financial instruments exchanges must also publicly disclose the total volume of daily transactions, highest price, lowest price, and closing price for each listed security. Such information must also be directly provided to the FSA.

The TSE publicizes pre-trade quotation information, as well as execution prices via its own market information dissemination systems.631 Pre-trade quote information is also available to the market via third-party distribution services, some of which integrate information from the TSE with information from other venues, including proprietary trading systems. Exchange trade data and quote information is available to all members in real time. The TSE also makes more detailed real-time information available to members for additional fees.

FIBOs are required to establish a policy and method for executing orders from customers under the best terms and conditions (“Best Execution Policy”) and execute orders in accordance with the Best Execution Policy. Before accepting an order from a customer, FIBOs need to deliver in advance to the customer a document stating the Best Execution Policy. FIBOs are prohibited from providing and promising special profits to a particular client. Unlike the United States and EU, Japan does not have detailed regulations regarding best execution, including a requirement for transparency.

All FIBOs and their directors and employees are also required to execute business in good faith and fairly to customers. Conflicts of interest must be prevented and appropriate management systems to identify them and address them must be developed. In addition, guidelines require that an independent conflict of interest manager be appointed to monitor different sales lines. These general rules concerning conflicts of interest and best execution apply to intermediaries routing customer orders regardless of whether those orders may be routed internally, to an affiliate or to another venue.

By the middle of 2010 (after information vendors introduced PTS price information streaming, the TSE started offering colocation services, and Japan Securities Clearing Corporation began offering clearing services for PTS) several FIBOs in Japan revised their Best Execution Policy to address smart order routing connections to PTSs. However, many FIBOs continue to use exchanges as the default execution venue, especially for retail customers.

Tick sizes on the TSE vary based on share price, with lower-priced stocks having smaller tick sizes. Proprietary trading systems (“PTSs”) initially defined their tick increments at about 1/10th those of the exchanges. Under pressure from PTSs, which began to directly compete with exchanges in 2005, the TSE reduced its tick sizes for highly-liquid stocks with large market capitalizations (the TOPIX100 constituents) over three stages.

MiFID 2 requires a share’s minimum tick size to be calibrated in terms of liquidity measured by the average daily number of transactions executed on the most relevant market. The regime applies equally, regardless of the currency of the financial instrument, as it determines only the minimum difference between the two price levels of orders sent in relation to a financial instrument in the order book.

The requirement applies to both orders and quotes. Originally, SIs did not need to comply with the tick size regime, but the regulatory standards were modified to extend the tick size regime to SIs for trades at or below standard market size.

MiFID 2 defines “algorithmic trading” as trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention.

MiFID 2 imposes organizational requirements on investment firms engaged in algorithmic trading, including requirements to put in place systems and risk controls of algorithms and keep sequenced records with respect to its trading activity. Firms must have both pre and post trade controls to monitor, identify and reduce trading risks across algorithmic trading activity. The aim of these requirements is to ensure the resilience of trading systems, to avoid the transmission of erroneous orders and to provide supervisors with information on the activities of algorithmic trading. Algorithmic traders that use market making strategies must enter into market making agreements with trading venues on which they operate, to ensure that they provide liquidity on a regular and predictable basis.

An investment firm engaging in algorithmic trading or providing direct electronic access must notify its Member State competent authority and the Member State competent authority of any trading venue of which it is a member. Its competent authority may require it to provide, on a regular or ad-hoc basis, (a) a description of the nature of its strategies, (b) details of the trading parameters or limits to which the system is subject, (c) a description of the key compliance and risk controls that it has in place and (d) information about the testing of its systems. The competent authority of the investment firm’s home jurisdiction is also required to communicate that information to the competent authority of the trading venue upon request.

Trading venues enabling or allowing algorithmic trading through their systems are also subject to various obligations, including certain organizational requirements, and requirements affecting capacity and resilience. Trading venues are required to provide testing platforms to ensure that algorithms can deal with stressed market conditions. Trading venues must also have in place certain pre-trade controls adopted for each instrument traded on them (price collars, maximum order value and maximum order volume) and can have such post-trade controls as they deem appropriate on the basis of their risk assessment. Trading venues must set limits on the number of order messages that a market participant can send relative to the number of transactions they undertake (the participant’s order-to-trade-ratio, or “OTR”). In addition, to enable retrospective reconstruction of trading activity by regulators, investment firms and trading venues must syn-chronize their clocks.

MiFID 2 defines “high frequency trading” or “HFT” as a subset of algorithmic trading characterized by: (a) infrastructure intended to minimize network and other types of latencies, including at least one of the these facilities for algorithmic order entry: co-location, proximity hosting or high-speed direct electronic access; (b) system-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders; and (c) high intraday message rates which constitute orders, quotes or cancellations.

HFT firms are subject to the obligations imposed on algorithmic trading firms generally and also must comply with further obligations. For example, HFT firms must store time-sequenced records of their algorithmic trading systems and trading algorithms for at least five years. Trading activity must be time-stamped with 100-microsecond accuracy. Further, ESMA has taken the position that high frequency traders should ‘immediately’ seek authorization as investment firms.

A salient characteristic of certain HFT strategies, including the market making and arbitrage activities described in Section 1f, is the submission, revision and or cancellation of a large number of orders within a short time period. The high number of order messages has given rise to concerns about the ability of IT systems at trading venues to handle these significant volumes. As noted earlier, MiFID 2 mandates that trading venues set limits on market participants’ OTR; MiFID 2 also allows, but does not require, OTR fees. Several European jurisdictions had already introduced OTR fees prior to MiFID 2. Italy was among the first jurisdictions to assess an OTR fee: Borsa Italiana, Italy’s main stock exchange, charges a fee-per-order that increases on a sliding scale based on a trader’s OTR. France implemented OTR fees as part of a legislative package that also included a financial transactions tax on certain stock transactions. A fee equal to 0.01% of the notional amount of modified or cancelled orders is imposed on financial intermediaries established in France whose OTR exceeds five. Notably, the OTR fee is directed only at HFT activities that are thought to be potentially harmful. Accordingly, activities pertaining to market making, smart order routing, and automated execution of large orders are exempt from the fee. Norway has also introduced OTR fees on the Oslo Stock Exchange; a fee of 0.05 Norwegian krone (NOK) per order is levied on traders with OTR higher than 70 to 1. The ratio is calculated on a monthly basis, and like the French OTR fee, is targeted only at activities that are perceived to be detrimental to market quality: orders that stay in the market for longer than a second, or that improve price or volume are not counted towards the OTR.

The separate Market Abuse Regulation (MAR) targets market manipulation. Though the MAR is targeted at market manipulation rather than algorithmic trading, it includes provisions that specifically mention algorithmic trading and HFT: it explicitly prohibits sending orders, including by means of algorithmic trading and HFT strategies, that would disrupt or delay the functioning of trading venues’ servers, make it difficult to identify genuine orders, or create or likely create misleading signals about the supply and demand of a financial product. Indicators of manipulative orders include the extent to which (1) trader’s orders represent a significant proportion of trading activity, (2) orders are concentrated in a short time-span, and (3) orders change the order book, as well as (4) position reversals and (5) whether orders are sent at a specific time in the trading session. Investment firms or trading venues that detect suspicious trading activity are required to report to their regulator.

In the EU, the primary volatility controls include measures on the provision of continuing liquidity, on circuit breakers and trading halts, and on trading venue capacity generally.

MiFID 2 requires trading venues to seek to ensure that they have in place a sufficient number of market-making agreements with investment firms to achieve liquidity, appropriate for the nature and the scale of their trading. Trading venues must also communicate the existence of stressed market conditions to all market makers. Exceptional circumstances, when the obligation to provide liquidity does not apply, are to be defined exhaustively. 

Further, trading venues are to have in place effective systems, procedures and arrangements to ensure that their trading systems have sufficient capacity to deal with peak order and message volumes, are able to ensure orderly trading under conditions of severe market stress, are fully tested to ensure such conditions are met, and are subject to effective business continuity arrangements to ensure continuity of their services if there is any failure of their trading systems. They should have effective systems, procedures and arrangements to reject orders that exceed pre-determined volume and price thresholds or are clearly erroneous.

Trading venue obligations include the need to have mechanisms in place to temporarily halt or constrain trading if there is a significant price movement in a financial instrument on that trading venue or a related trading venue during a short period and, in exceptional cases, to be able to cancel, vary or correct any transaction (a circuit breaker). The trading venue with the highest turnover in a financial instrument in the EU has to have necessary systems and procedures in place to notify its competent authority that its circuit breaker has been triggered and its trading halts applied, so that a market-wide response could be put in place, if appropriate.

ESMA has issued guidelines on the calibration of circuit breakers and publication of trading halts under MiFID 2. The calibration is to be done according to a pre-defined, statistically supported methodology, taking into account factors such as the nature of the financial instrument, the liquidity profile and the quotation level of the financial instrument, the volatility profile of the financial instrument, the order imbalance (when manual re-calibration may be required), and static and dynamic reference prices (unless the trading venue can demonstrate that only one of those categories is sufficient).

MiFID 2 requires investment firms engaged in algorithmic trading to have emergency “kill functionality,” allowing them to cancel all of their unexecuted orders with immediate effect, where that becomes necessary.

Trading venues must have systems and procedures in place to ensure that algorithmic trading cannot create or contribute to disorderly trading conditions. This includes an obligation to calculate the ratio of unexecuted orders to transactions effectively incurred by their members or participants at the level of each financial instrument traded on them, in order to ensure effectively that the ratio does not lead to excessive volatility in that instrument.

Until the mid-2000s, the U.S. equity markets were dominated by exchange-based floor trading. This manual market landscape had some marked differences from the modern structure. For example, trading was highly centralized and competition among trading venues was limited. At the same time, there are similarities between the manual and modern market structure, such as the existence of undisplayed or “dark” trading and broker-dealer internalization.

Once automated electronic communication systems proliferated in the late 1990s, broker-dealers began to use these technologies to implement trading systems that challenged the dominance of the exchange-based manual model. In 1998, the SEC adopted Regulation ATS (“Reg ATS”), subjecting these trading venues to regulation.

Despite the advent of electronic marketplaces, certain regulations that were in place until 2006 gave a competitive advantage to slower manual markets for exchange-listed stocks. In 2006, the implementation of Regulation National Market System (“Reg NMS”) reshaped the equity market regulatory structure by spurring competition among trading venues, leading to the automation of equity markets and lowering investor transaction costs.

As of September 2017, dark trading accounted for approximately 45% of trading in U.S. equity markets, largely flat since 2014. It can take place across all three types of trading venues. The vast majority of trading on ATSs and broker-dealer internalization can be considered dark trading, and approximately 9% of trading on exchanges involves the execution of undisplayed interest.

There are no caps on dark trading in U.S. equity markets. However, any dark trading must occur in a manner consistent with Reg NMS.

Stock exchanges

The Exchange Act defines an exchange as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities.” The Exchange Act provides that an exchange may seek to register as a “national securities exchange” by publicly filing an application with the SEC.

The key requirements that apply to exchanges are set forth in the Exchange Act and in regulations promulgated thereunder by the SEC. Under the Exchange Act, exchanges must permit any registered broker-dealer in good standing to become a member of the exchange. Exchanges must file their proposed rules, which cover trading at the exchange and member conduct, for public comment and SEC approval before they can go into effect. In addition, exchanges are the only trading venues that are “self-regulatory organizations” (“SROs”). As SROs, exchanges must have the capacity to carry out the purposes of the Exchange Act and to enforce compliance by their members with the Exchange Act and related exchange rules. Such enforcement is generally achieved through disciplinary proceedings and membership restrictions, for which the Exchange Act also sets forth guidelines.

Alternative trading systems

In 1998, the SEC implemented Reg ATS and established a new category of trading venue regulation, the alternative trading system (“ATS”). This new type of trading venue was designed to respond to the proliferation of automated trading platforms that market participants had developed, which “furnish[ed] services traditionally provided solely by registered exchanges.” Although these electronic venues meet the Exchange Act definition of exchange, Reg ATS exempts them from exchange registration if they comply with Reg ATS and their operators are registered as broker-dealers.

Reg ATS requires that an ATS’s rules can only pertain to its subscribers’ trading conduct, and ATSs can only discipline subscribers by excluding them from trading. Unlike an exchange, an ATS can effect trading rules without the SEC’s preapproval. ATSs can also limit access to trading on their platform and can restrict participation among its subscribers, unless their average daily trading volume in a particular stock equals or exceeds approximately 5% of overall trading volume in that stock. If trading volume on an ATS exceeds the 5% threshold, then the ATS must establish written standards for granting open access to all registered broker-dealers seeking to trade that stock on the ATS.

ATSs are not required to publicly display orders, unless: (1) their trading volume in a stock equals or exceeds 5% of total trading in that stock; and (2) the ATS displays prices to more than one of its participants (i.e., it is not a “dark pool”). If an ATS exceeds the 5% threshold, then it must publicly display orders in that stock, but no ATSs presently exceed the threshold.

The SEC amended Reg ATS in July 2018 to enhance operational transparency and regulatory oversight of ATSs. The new rule requires ATSs to file and update a Form ATS-N with the SEC, which will be made publicly available. Form ATS-N requires public disclosure for the first time of information regarding each ATS’s rules, services, fee structures, trading activity by the operators, and procedures regarding confidential customer information.

Order protection rule

An order that is executed at a worse price than the best publicly available price is known as a “trade-through.” The SEC adopted Rule 611 of Reg NMS (the “order protection rule”) to reduce trade-throughs by requiring exchanges, ATSs and broker-dealer internalizers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trade-throughs of “protected quotations.” Protected quotations are the best, automated, publicly displayed bids and offers on each exchange and the Alternative Display Facility operated by FINRA (which would include publicly displayed quotes from ATSs if they exceeded the 5% threshold, but none have). While the rule restricts order execution at a price worse than the NBBO, trading venues can execute at a price matching the NBBO, even if they are not publicly displaying that price.

Trading venue execution disclosures

To enhance transparency with respect to order execution, Rule 605 of Reg NMS requires all trading venues (including exchanges, ATSs, and broker-dealer internalizers) to publicly disclose monthly reports with standardized information about the order execution quality they achieve for retail-size customer orders. The report must contain detailed information categorized by individual security, order type, and order size for all securities that the trading venue executes. It must include the speed at which orders are executed and the “average realized spread” (calculated with reference to the weighted price obtained versus the midpoint of the NBBO).

As to speed, Rule 605 currently requires trading venues to disclose the speed of execution to the tenth of a second. As to price, execution quality reported under Rule 605 is measured using the NBBO as disseminated by the SIP feeds. In emphasizing the required use of SIP-based NBBOs, the SEC staff has explained that benchmarking executions across market centers to the same reference points would further the important objective of generating “execution quality statistics that are comparable among different market centers.”

Together, these obligations assist investors, regulators, trading venues and broker-dealers in assessing effective compliance with the duty of best execution.

Access fees

Investors would not be able to obtain the best prices for their orders if broker-dealers could not access trading venues in a fair and efficient manner. Rule 610 of Reg NMS sets forth the rules by which market participants may access trading venues.

Trading venues have the authority to impose “access fees” on market participants executing trades on their platform. This is subject, however, to the overall requirements of the Securities Exchange Act of 1934, including the requirements of Section 6 that, among other things, an exchange’s rules must provide for the ‘equitable allocation of reasonable dues, fees, and other charges among its members and issuers and other persons using its facilities’, not ‘permit unfair discrimination between customers, issuers, brokers, or dealers’, and ‘not impose any burden on competition not necessary or appropriate in furtherance of the purposes of’ the Securities Exchange Act. SROs/exchanges must have their rules and proposed rule changes approved by the SEC. Since the Dodd-Frank Act in 2010, the exchanges have an option to designate their fee rules as immediately effective upon filing with the SEC, but the SEC can suspend such an immediately effective rule. In October 2019, to strengthen the considered review of fee changes, the SEC proposed to rescind the current exception allowing exchange fee changes to become immediately effective upon filing.

Because access fees are not expressly reflected in a stock’s publicly displayed price, and SEC Rule 611 mandates that best price protected quotes must be honored, the SEC implemented an access fee cap of $0.0030 per share for publicly displayed orders. In practice, exchanges often charge the regulatory maximum as part of the “maker-taker” pricing system, whereby exchanges charge a fee to the market participants that remove (“take”) liquidity from an exchange and pay a rebate to market participants that provide (“make”) liquidity to an exchange. Access fees are generally used to fund liquidity rebates, and exchanges earn the difference.

Access fee pilot program

In December 2018, the SEC adopted Rule 610T of Regulation NMS to implement a transaction fee pilot program (the “Fee Pilot”) to “help the Commission analyze the effects of exchange transaction fee and rebate pricing models on order routing behavior, execution quality, and market quality generally.” The Fee Pilot covers all exchanges and is to last one year with the prospect of a one-year extension by the SEC. The Fee Pilot will include stocks that meet certain trading volume and price thresholds (the “Fee Pilot Securities”).

The Fee Pilot Securities are divided into three groups. For Test Group 1, the access fee cap applicable to exchanges is reduced to $0.0010. For Test Group 2, the access fee cap applicable to exchanges remains at $0.0030, but rebates are generally prohibited. For the Control Group, the access fee cap applicable to exchanges remains at $0.0030.

In addition, the Fee Pilot requires exchanges to post the following to their websites: (i) transaction fee and rebate data on a monthly basis; and (ii) information about the Fee Pilot Securities they list and any changes to trading in those securities. Exchanges must also provide the SEC with aggregated order routing data on a monthly basis.

The access fee pilot program reduces the ability of exchanges to implement a maker-taker pricing system. Three exchange groups (NYSE, Nasdaq and Cboe Global Markets) have sued the SEC to challenge the Fee Pilot on the grounds that it is arbitrary and capricious and exceeds the SEC’s rulemaking authority under the Administrative Procedure Act.

Market data fees

The US has a two-pronged system of market data (and market access) in equity markets, (1) the consolidated data feeds distributed pursuant to joint-SRO national market system plans; and (2) the proprietary data products and access services that are provided directly by the exchanges. The latter set of products has less latency, include slightly different content (for example, proprietary feeds have depth of book information, which the SIPs do not, and SIPs have certain regulatory information, which the proprietary feeds do not), and is more costly. The cost of the proprietary data products has been increasing over time and has become a contentious issue between the users and the dominant exchanges (NYSE and Nasdaq) who have the most valuable data streams.

The SEC issued guidance on May 21, 2019, as to the level of detail it expects to see from the exchanges when they seek to increase the fees they charge for market data. The details required include measuring down to the microsecond a faster data product, and showing the costs of producing data, if exchanges are using the cost as a basis for justifying their higher fees.

Pursuant to the Exchange Act, the SEC aims to ensure that market participants have access to consolidated market data at fair cost and in an effective and timely manner. Consolidated market data generally refers to: (1) pre-trade transparency – timely information on the best-priced publicly displayed quotations; and (2) post-trade transparency – timely reports of trades that are executed.

“Lit” trading, or trading with pre-trade transparency, refers to trading on venues with publicly displayed quotes that include: (1) the stock symbol, (2) whether the order is one to buy or to sell, (3) the number of shares, and (4) the price. Undisplayed or “dark” trading describes trades that are executed on venues without such pre-trade transparency and the execution of undisplayed interest on an otherwise lit venue. Pre-trade transparency serves an essential linkage function by helping to inform the public of the best displayed prices for stocks. There are no pre-trade transparency obligations in relation to odd lots, although some exchanges do provide odd lot quotations.

Trades executed in the dark are still subject to “post-trade transparency.”  Post-trade transparency together with pre-trade transparency enables investors to monitor the prices at which orders are executed and assess whether their orders received best execution.

Trading venues and broker-dealers must have access to consolidated market data in order to comply with the order protection rule and duty of best execution.

There are two ways that market participants can obtain consolidated market data. The first is via the securities information processors (“SIPs”), which are governed by Reg NMS plans. Each NMS plan utilizes one SIP, and there are currently two SIPs operated by a committee of exchanges: one for Nasdaq-listed securities (under the UTP Plan), and another for securities listed on NYSE and other exchanges (under the CTA Plan). Reg NMS requires trading venues to submit real-time quotation and trade information to the SIPs, which aggregate and disseminate consolidated market data. According to Reg NMS, consolidated data for each individual NMS stock must be disseminated through a single SIP under an NMS Plan. Because NMS Plans must designate a single SIP for each NMS Stock and only SROs are permitted to file NMS Plans, SROs determine the SIP for each NMS Stock. SROs charge market participants to access SIP data. Although the SEC must approve SIP fees, changes to them can be deemed effective when filed with the SEC. Under Rule 603(a)(1) of Reg NMS, when a trading venue distributes core data for NMS Stocks through a SIP, the data must be sold “on terms that are fair and reasonable.”

Second, market participants can also privately purchase core and non-core market data directly from trading venues and consolidate it themselves. Reg NMS permits trading venues to sell access to their own “proprietary” data feeds, which are used for this purpose. Rule 603(a)(2) of Reg NMS requires all trading venues that sell these proprietary data feeds to make their data feeds available “on terms that are not unreasonably discriminatory.”

In October 2018, pursuant to this statutory authority and Rule 603(a) of Reg NMS, the SEC set aside core market data fee increases by NYSE Arca and Nasdaq on the grounds that the exchanges failed to meet the burden of showing the fees are fair and reasonable. In light of that decision, the SEC also remanded several other challenges to exchange fees for the exchanges to further review the fee increases (with respect to fairness and reasonableness) and develop procedures to assess their validity under the Exchange Act and, “if appropriate, resubmission to the Commission.” Several motions to reconsider the remand order remain pending before the SEC.

The duty of best execution requires broker-dealers to execute customer trades at the most favorable terms reasonably available under the circumstances. It derives, in part, from common law principles that obligate an agent to act exclusively in its principal’s best interest, and also has been incorporated explicitly in FINRA rules. Accordingly, broker-dealers that are FINRA members have best execution duties whether they are acting as an agent on behalf of a customer or whether they are trading with a customer in a principal capacity with a customer.

FINRA’s best execution rule requires that, “[i]n any transaction for or with a customer or a customer of another broker-dealer, a member and persons associated with a member shall use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.” Broker-dealers must consider a number of factors to help them identify the best terms reasonably available. The factors that are considered in determining whether a firm has used “reasonable diligence” include: (1) the character of the market for the security (e.g., price, volatility, relative liquidity and pressure on available communications); (2) the size and type of transaction; (3) the number of markets checked; (4) accessibility of the quotation; and (5) the terms and conditions of the order which result in the transaction.

Broker-dealer internalization

Broker-dealer internalization generally involves a broker-dealer executing customer orders against its own inventory of stocks. Broker-dealer internalizers do not meet the Exchange Act definition of an exchange, because they primarily execute trades as a principal and only incidentally match the undisplayed orders of their customers. Accordingly, they do not have to register as an exchange under the Exchange Act or an ATS under Reg ATS. Instead, broker-dealer internalizers must register as members of FINRA. FINRA membership carries with it a number of regulatory obligations, such as examination, licensing, and reporting requirements. Further, broker-dealer internalizers are subject to additional SEC requirements if they meet the definition of “market center,” including the requirement to file Rule 605 execution quality reports.

Payment for order flow

Retail broker-dealers often route their orders to broker-dealer internalizers acting as market makers in the relevant security in order to obtain price improvement. These broker-dealer internalizers often execute retail orders as part of payment for order flow (“PFOF”) agreements with the retail broker-dealer. Under a typical PFOF agreement, the broker-dealer internalizer pays the retail brokerage to direct retail order flow to the broker-dealer internalizer for execution. Broker-dealer internalizers compete to offer price improvement to the best publicly displayed price available on an exchange. Rule 606 of Reg NMS requires retail brokerages to report information about their PFOF arrangements in quarterly public filings.

Broker order-routing disclosure rule

On November 2, 2018, the SEC amended Rule 606 of Reg NMS to require greater disclosure from broker-dealers with respect to order routing, payments to and from trading venues, payments for order flow, and maker-taker arrangements.

Newly-adopted Rule 606(b)(3) requires a broker-dealer, upon the request of an institutional customer, to provide its customer with disclosures concerning the handling, routing and execution of customer orders, including fees paid and rebates received from trading venues. Prior to the amendments, Rule 606(a) already required, among other things, broker-dealers that route customer orders to provide a quarterly public report with order routing information, including a description of the material aspects of their relationships with the venues to which they routed the most orders (“Specified Venues”). Under the new rule as amended, this includes the top ten venues as well as any venue to which the broker routed more than 5% of its non-directed orders. Amendments to Rule 606(a) require that: “for each Specified Venue, the broker-dealer report the net aggregate amount of any payment for order flow received, payment from any profit-sharing relationship received, transaction fees paid, and transaction rebates received. Broker-dealers must publicize these reports online for three years. Together, the rules require greater transparency with respect to order routing in general and compensation arrangements in particular.

Tick sizes are the minimum price variation (“MPV”) for quotations for stocks. Prior to 2000, the majority of exchanges set tick sizes at fractions (e.g., 1/8th) of a dollar. But in 2000, the SEC directed the exchanges to develop a plan to convert their quotations from fractions to decimals, primarily because fractional tick sizes were creating wide spreads and increasing transaction costs for investors. The SEC set the current MPV at one cent for listed stocks that trade above $1 per share. Rule 612 of Reg NMS, the “sub-penny rule,” generally prohibits any trading venue from publicly displaying, ranking, or accepting orders in increments smaller than one penny.

Tick size pilot program

The SEC approved a Tick Size Pilot Program that commenced on October 2016 and ran for two years as scheduled. Under the program, the MPV for certain smaller-capitalization stocks was temporarily increased to $0.05 in order to examine the effect of larger minimum tick sizes on liquidity. The exchanges and FINRA submitted a joint assessment of the impact of the program to the SEC in August 2018, and the program expired in September 2018. The FINRA assessment revealed relatively unimpressive results and found that the program: (i) may have increased liquidity displayed at the NBBO, but also widened effective spreads; (ii) did not appear to increase the number of market makers per security, but it did increase their volume and profit; and (iii) appears to have driven some trading off-exchange. But the SEC has not publicized its conclusions on the results and implications of the program. There are presently no plans for the SEC to increase the MPV of smaller capitalization stocks to $0.05.

In the United States, there are no regulatory definitions or requirements that apply specifically to traders engaged in electronic trading, algorithmic trading or HFT in equity markets. However, any firm trading directly on an exchange must (i) be a registered broker-dealer with the SEC and (ii) become a member of an SRO, including FINRA and/or one of the national securities exchanges. Therefore, if a firm engaged in algorithmic trading or HFT seeks to trade directly on an exchange, then it would be subject to the regulatory requirements that apply to broker-dealers.

The SEC, FINRA and the national securities exchanges have adopted rules applying risk-controls to broker-dealers that increase in stringency based on their activities. For example, FINRA’s Net Capital Rule requires broker-dealers to maintain minimum levels of liquid assets, or net capital. In addition, the SEC requires broker-dealers with access to trading on an exchange or ATS to maintain “risk management controls and supervisory procedures that, among other things, are reasonably designed to (1) systematically limit the financial exposure of the broker or dealer that could arise as a result of market access, and (2) ensure compliance with all regulatory requirements[.]” NASDAQ’s rules for broker-dealer members explicitly incorporate FINRA’s requirement that members establish a supervisory control system to ensure compliance with applicable rules and regulations. NYSE rules set a ceiling on the number of shares eligible for automatic order execution, implicitly limiting the size of orders that can be entered in an automated fashion. For its part, FINRA guidance indicates that it views the requirement to publish only bona fide offers to buy or sell as being relevant to algorithmic trading, even if the rule itself does not specifically single HFT strategies. The SEC has also approved exchange rules prohibiting their members from engaging in or facilitating disruptive quoting and trading activity and giving the power to cut off-exchange access when a member engages in such activity. Thus, although U.S. securities markets lack a regulatory regime that specifically addresses algorithmic trading or HFT, registered broker-dealers are subject to various SEC and SRO regulations that ultimately do govern algorithmic trading and HFT. 

Firms that do not trade directly on an exchange (and are therefore not required to register as broker-dealers) can obtain “sponsored” access to an exchange through a registered broker-dealer. SEC Rule 15c3-5 imposes minimum standards on these arrangements that are also intended to mitigate trading risk. For example, broker-dealers may only provide a market participant with sponsored access if the broker-dealer has established reasonable credit and capital thresholds for the market participant. The broker-dealer must also maintain risk management controls and supervisory procedures for the market participant. These standards are intended to mitigate the risk that a market participant with sponsored access could cause solvency concerns for the broker-dealer or volatility in the markets.

In 2014, the SEC adopted Regulation Systems Compliance and Integrity (“Reg SCI”), which imposes compliance and monitoring requirements on most trading venues, including exchanges and ATSs that exceed certain volume thresholds. Reg SCI enhances the SEC’s oversight of U.S. securities markets’ technology infrastructure in order to reduce the occurrence of systems issues and improving resiliency when such issues do occur.

Relatedly, the SEC has taken steps to improve its ability to perform ongoing surveillance and reconstruct market activity. In 2011, the SEC imposed registration and reporting requirements on traders that exceed defined volume thresholds, which allow the SEC to see how these major traders interact with securities markets and reconstruct trading activity following periods of extreme market volatility. Likewise, in 2013, the SEC introduced the Market Information Data Analytics System (MIDAS), its official trade monitoring system; MIDAS gives the SEC the ability to reconstruct trading activity after extreme market events and detect illegal trading behavior. In addition, in 2012 the SEC adopted Rule 613, requiring national securities exchanges and FINRA to submit plans to create, implement, and maintain a consolidated audit trail designed to track the life cycle of all orders and trades, in order to allow regulators to track market activity more accurately and efficiently. By creating a central repository of trading data, the SEC and other regulators aim to link customer account information to order event data and perform ongoing surveillance while also enabling complete market reconstructions.

The SEC has focused its enforcement resources on policing forms of market manipulation, such as quote stuffing (sending and instantly canceling a large number of orders to cause delays in execution of the orders of other traders), smoking (posting short-lived quotes inside the spread to tease slower traders to cross the spread) and spoofing (posting quotes away from the spread in order to create the illusion of trading interest). Although these activities can be facilitated using algorithmic trading, they are also employed by human beings to take advantage of other traders using legitimate algorithmic trading strategies.

The SEC has indicated that additional regulation of HFT firms may be on the horizon. In 2015, the SEC proposed eliminating or narrowing exemptions that allow some HFT firms to forego FINRA registration, which would expand the number of HFT firms subject to FINRA examinations and enforcement actions. The proposed rule has not yet been finalized. However, the SEC has approved a 2016 amendment to FINRA’s rules that requires each person who is primarily responsible for the design, development or significant modification of an algorithmic trading strategy relating to equity securities, or who is responsible for the day-to-day supervision or direction of such activities, to register with FINRA as a “securities trader” and pass qualification exams.

Market-wide circuit-breakers

Market-wide circuit breakers are designed to briefly shut down trading in all stocks across all trading venues to promote the orderly functioning of markets. Shutting down trading during periods of high volatility can promote the orderly functioning of markets, because doing so provides market participants with additional time to assess new information and significant changes in market prices and to adjust automated trading systems that may be executing trades at unintended prices. This can reduce the market impact of abrupt price movements. The SEC’s market-wide circuit breakers are triggered at price declines of 7%, 13%, and 20%. The SEC uses the S&P 500 as the reference index.

Trading halts for individual stocks

In 2012, the SEC approved the “Limit Up-Limit Down” (“LULD”) mechanism, proposed in a Reg NMS plan put forward by the US exchanges and FINRA, to address extraordinary market volatility. The LULD mechanism provides market-wide, single stock price bands that ‘are designed to prevent trades in individual NMS stocks outside of specified price bands, while allowing trading to continue when the price move is transitory’. Trading in a security is paused for five minutes if price volatility is not quickly corrected (i.e., if, but-for the pause, orders would execute outside of the band). LULD thus protects market participants from trading at extreme and unintended prices and provides time for them to adjust their orders during periods of volatility. The price band for each stock is calculated by the SIP responsible for consolidating information for each NMS stock. The plan defines price bands for two distinct group of securities, Tier 1 NMS Stock (S&P 500, the Russell 1000, and some high-volume exchange-traded ETFs) and Tier 2 NMS Stock (the remainder of the NMS stocks).

The width of LULD price bands doubles at the close of trading, between 3:35pm and 4:00 pm (or in the case of an early scheduled close, during the last 25 minutes of trading before the early scheduled close), for all stocks except Tier 2 NMS Stock with a reference price above $3.00.

Price collars

In addition to the operation of the LULD mechanism, some US exchanges have in place rules that provide for price collars in their opening, closing and/or reopening auctions, to reduce the risk of a poor execution price. For example, NYSE American has price collar thresholds for the indicative match price for its core open auctions, trading halt auctions and closing auctions, with the collar being based on a price that is the greater of $0.50 or 10% away from the auction reference price.

“Breaking” clearly erroneous trades

SROs have the authority necessary to cancel, or “break,” trades on any trading venue, if a trade exceeded a minimum percentage deviation from the last trade. In other words, two counterparties that entered into a trade on an exchange would no longer be bound by their trade if an exchange broke that trade. Similarly, FINRA can break the trades of ATSs and broker-dealer internalizers. This power to nullify trades protects investors from being bound by unintentional trades at terms they clearly would not have intended to accept, thereby promoting fair and orderly markets.

Kill switches

Kill switches halt trading for a specific market participant on a trading venue when that entity’s trading activity has breached a pre-established exposure threshold on that trading venue. They are thus intended to prevent a specific market participant’s erroneous orders or uncontrolled accumulation of unintended positions. Certain exchanges currently offer kill switches for broker-dealer members, but they are optional and non-uniform.

Regulatory trading halts

Exchanges have the authority to call regulatory trading halts for their listed securities under the NMS Plans that cover NYSE-listed securities and NASDAQ-listed securities. Once a listing exchange decides a regulatory halt is appropriate and institutes one, the listing exchange must notify the other SROs. Regulatory trading halts are generally effective across all trading venues.

Regulatory trading halts may be called due to (i) inadequate or pending disclosure of material information to the public; or (ii) “regulatory problems relating to” a security “that should be clarified before trading therein is permitted to continue,” including extraordinary market activity due to system misuse or malfunction.