By Matthias Burghardt, Head of Xitaro Exchange System Development, Boerse Stuttgart
If you consider MiFID II testing requirements are a challenge, you might have a problem with your established processes today.
Boerse Stuttgart is approaching the last quarter of a two-year Markets in Financial Instruments Directive (MiFID) II project which is dominated by development and testing activities. MiFID II requires trading venues and investment firms to implement substantial changes in existing processes and technology. As Boerse Stuttgart Group operates not only a trading venue but also an investment firm, EUWAX AG, requirements have to be fulfilled for both entities. Before work was carried out an examination was needed to identify the differences and commonalities in requirements between investment firms and trading venues.
MiFID II testing requirements on investment firms and trading venues are based on Articles 17 and 48 and are further specified in the regulatory technical standards 6 and 7. Article 17 requires investment firms engaged in algorithmic trading to ensure their systems are fully tested. Article 48 requires regulated markets to ensure their trading systems can perform orderly trading under conditions of severe market stress and meet strict testing criteria. In addition, regulated markets shall require members to carry out appropriate testing of algorithms and provide environments to facilitate such testing. According to Article 18(5) these requirements do not only apply to regulated markets but to multilateral trading facilities (MTFs) and organised trading facilities (OTFs) as well.
Regulatory Technical Standards (RTS) 6 and 7 provide the details on MiFID II’s testing requirements for investment firms and trading venues, respectively.
There are six areas to consider when implementing MiFID II: Staffing, general testing methodology, conformance and algorithm testing, testing environments, stress testing and the role of self-assessments. Let’s explore in more detail.
1) Staffing: You need to have a sufficient number of qualified and expert staff to manage your trading systems and algorithms. The requirements on investment firms and trading venues are remarkably similar, but investment firms need to have staff with technical knowledge of trading systems, algorithms and strategies. Trading venues need to have staff with knowledge of the trading systems, algorithms and the types of trading undertaken by the members.
2) General testing methodology: MiFID II requirements on the general testing methodology may not be new, but it’s wise to check your processes and documentation. The goal of testing is to ensure that systems do not behave in an unintended manner. But, similar to the staffing requirement, stakes are higher for investment firms than for trading venues.
Investment firms should establish clearly delineated methodologies to develop and test their systems, algorithms or strategies. They should also adapt their testing methodologies to the trading venues and markets where the trading algorithm will be deployed. On the other hand, trading venues are required to make use of clearly defined development and testing methodologies and be able to demonstrate at all times that they have taken all reasonable steps to avoid their trading systems contributing to disorderly trading.
3) Conformance and algorithm testing: Investment firms and trading venues must work together to ensure conformance of the investment firm’s trading algorithms with the trading system. Trading venues must require their members to test the conformance of the investment firm’s algorithmic trading systems with the system of the trading venue. In particular, conformance testing should prove that the systems interact as intended, verify basic functionalities, test connectivity and recovery. Trading venues should document the results by issuing a conformance test report.
In addition to conformance testing which covers only the basic functionality, trading venues must require members to certify that their algorithms have been tested to avoid contributing to or creating disorderly trading conditions. This is a task investment firms can do without any interaction with the trading venue. However, before an algorithm is deployed, investment firms must certify and explain their algorithm testing activities to the trading venues. Trading venues are expected to include all testing obligations in their rules and regulations. Critically, conformance testing is made a condition in the due diligence for members of trading venues.
4) Testing environments must be strictly separated from production environments in both investment firms and trading venues. Investment firms should use a testing environment separated from production. Some firms may opt to use testing environments provided by a trading venue, direct electronic access (DEA) provider or vendor, but they need to retain full responsibility. They also need to use their testing environment for stress tests.
Trading venues should provide a conformance testing environment and require members to use it. Despite there being no strict requirement for members to use it, they should also provide access to an algorithmic testing environment which is as realistic as possible.
5) Stress tests shall be used by investment firms and trading venues, respectively, to verify their systems’ performance. Investment firms must – as part of their annual self-assessment – test that algorithmic trading systems can withstand increased order flows or market stresses. This is done by running high message and trade volume tests using twice the number/volume of the last six months maximum. Trading venues should – in the context of their self-assessment – simulate adverse scenarios, including members’ activities in all trading phases, segments and instruments.
Adverse scenario tests should be based on an increased number of messages received (baseline is the highest number of messages per second during the last five years), unexpected behaviour and a random combination of normal and stressed market conditions. It is important to note that stress tests are executed separately by investment firms and trading venues and have a different focus. Investment firms concentrate on testing an increased system load whereas trading venues concentrate their testing activities on adverse scenarios and an unexpected behaviour of their operational functions. There is no requirement regarding common stress testing activities.
6) Self assessments should be regarded by investment firms and trading venues as an opportunity to determine their specific MiFID II implementation needs. Investment firms are required to perform an annual self-assessment considering nature, scale and complexity of their business. Similarly, trading venues should perform a self-assessment at least once a year, but before the deployment of a trading system.
According to RTS 6 recital 8, compliance with the specific organisational requirements for investment firms should be determined according to a self-assessment. Similarly, trading venues should – according to RTS 7 recital 5 – lay down their requirements with respect to their systems and apply them in conjunction with a self-assessment since not all trading models present the same risks. Therefore, some organisational requirements may not be appropriate for certain trading models. In particular, the specific requirements to be set should be considered according to the nature, scale and complexity of the algorithmic trading activity.
In other words, the European Securities and Markets Authority (ESMA) acknowledges that: (a) investment firms and markets are not necessarily equal in terms of nature, scale and complexity; (b) the specific application of requirements may take these differences into consideration; and (c) self-assessments could be considered a chance to explain the specific implementation measures.
If you consider MiFID II testing requirements a challenge, you might have a problem with your established processes today.
Most of the requirements are probably already fulfilled by markets and their participants. MiFID II imposes the same standards on each investment firm and on each trading venue making it a level playing field. However, requirements on investment firms are higher than on trading venues. You probably do not have to implement completely new processes, but you may need to verify this and update your documentation. And last but not least, self-assessments need to be performed at least annually and don’t forget they are also a chance to explain your MiFID II compliance to your regulator.
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