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Will Italy’s financial transaction tax (FTT) become a blueprint for the regulation of high-frequency trading in Europe? France and Germany have already introduced measures, the UK wants to assess potential impact and, at the EU level, MiFID II includes related proposals. Chris Morris and Marco Ragusa of Ernst & Young explore the recent developments.
High-speed trading tax for Italy
Financial Times, 2 September 2013: A new high-frequency trading tax is being introduced in Italy, despite warnings from banks and brokers over potential damage to liquidity on the nation’s markets. The levy will apply to high speed trading in equities and equity derivatives on Italian Markets. The European Commission has proposed a tax on financial transactions which has gained the backing of 11 Eurozone countries and it is possible that a similar proposal for a tax on high frequency trading may be put forward in the context of the wider European Financial Transactions tax.
How does high frequency trading operate?
High frequency trading has increased substantially in recent years and now accounts for a significant proportion of equity trading activity in the US, UK and Europe. These trading strategies employ sophisticated computer algorithms to search for trading opportunities in the markets, using technology to execute these strategies with very ‘low latency’ between the arrival of market information and the reaction of the computer to place, amend or cancel an existing order.
How have different jurisdictions sought to regulate such trading?
In Europe, there has been much discussion about the effects of high frequency trading and the need for control of such activities whether by way of regulation or taxation. France has already imposed a tax on certain high frequency trading activities and Italy has followed suit with their own version.
What is the scope of the tax on high frequency tax in Italy?
Italy’s FTT includes an additional special levy that applies to ‘high-frequency trading’ transactions, the High Frequency Tax (or HFT). Unlike the FTT, the HFT applies to sell as well as buy orders. It applies to a transaction if it is generated by an algorithm which automatically makes decisions concerning the generation, modification or cancellation of orders (and of the relevant parameters for generating, modifying and cancelling those orders) and that transaction occurs within a specified time interval. That time interval is defined as 500 milliseconds (or less) and is measured from the time a buy or a sell order is placed to the time of the subsequent cancellation or modification of that order by the same algorithm that generated it.
Algorithms used solely for the fulfillment of client orders to comply with MIFID 2004/39/EC best execution requirements are exempt as are algorithms used solely for the purpose of complying with best execution requirements for clients under foreign regulations. An exemption also operates for algorithms used for market making (as defined) provided that buy and sell orders generated by such algorithms come from specific desks devoted to market making as set out in the Stability Bill and Final Decree.
The HFT applies on a daily basis by International Securities Identification Number (ISIN) and by client to transactions executed in the Italian Financial Markets. It is payable where in a single trading day, the ratio between the sum of cancelled orders and modified orders and the sum of entered orders and modified orders on that instrument exceeds 60%. The HFT arises at the rate of 2bps on the value of cancelled and modified orders exceeding the 60% threshold for that day. For these purposes, Italian financial markets includes the Borsa Italiana and related markets including the derivatives market but excludes markets outside Italy including the LSE, NYSE and multi-lateral trading platforms (MTFs) based in London and elsewhere outside Italy.
What are some of the key considerations surrounding the introduction of the tax?
The tax was introduced mainly due to concerns that the increasing prevalence of high-frequency trading activities could potentially adversely affect the integrity and quality of the Italian financial markets and in particular affect their volatility and liquidity.
For this reason, although enacted in the same legislation, the HFT is fundamentally different and in some respects broader than the FTT. For instance, as mentioned above, the HFT applies to sell as well as buy orders and unlike the FTT it can effectively cascade where the execution of an order is preceded by a number of modifications or cancellations.
In addition, it also applies to transactions over non-Italian equities (as well as derivatives over those equities) if executed on the Italian market. It also applies to Italian equities and derivatives which are out of scope for FTT purposes by virtue of being below the market capitalization threshold of €500 million (as defined). The FTT itself does not apply to transfers of shares traded in regulated markets and MTFs which are issued by companies who have a market capitalization of less than €500 million as defined in the Stability Bill and Final Decree.
There have been significant operational challenges and costs to implementing the HFT. This has particularly been the case for intermediaries who are generally responsible for collecting the tax on behalf of clients in the same manner as they are for FTT. Where a client algorithm is operating via direct market access through a particular broker, for instance, that broker would be responsible for applying and remitting the tax and so would need systems capable of applying the required limits and calculating the HFT on a real time basis. This may be particularly problematic where a client is trading the same ISIN through several different brokers.
This has meant significant additional cost and system build for intermediaries relative to the FTT as well as increased operational complexity and risk.
What are the practical effects likely to be?
Costs of implementation aside, we are expecting the practical effect of the HFT to be relatively modest in the short term as the level of algorithmic trading of the kind that would be caught is understood to be relatively low in the Italian markets. In addition, it is expected that algorithmic traders will adjust their trading patterns accordingly should the HFT become a significant cost. They could do this by moving trading out of Italian markets or by simply not exceeding the 60% intraday limits.
What is the position in other jurisdictions?
There has recently been significant discussion in this area across Europe.
The German Parliament adopted the Hochfrequenzhandelsgesetz (High Frequency Trading Act) in February of this year, which entered into force on 15 May 2013. Under this legislation, traders using high frequency trading platforms are required to apply for a license with BaFin (the German Federal Financial Services Supervisory Authority) and provide details of their algorithms and how they operate on demand. This requirement applies to all those trading on the MTF, either directly or indirectly (which remains undefined) and as such, this will affect traders globally. In addition, the German derivatives exchange, Eurex, has recently introduced a penalty regime aimed at high frequency trading activity. The regime will apply for a two month test period and will incorporate controls which will include an order-to-trade ratio. Eurex will also apply a penalty for ‘excessive system usage’ which will be calculated on a daily limit for the number of transactions sent by a single participant.
At the EU level, MiFID II contains similar proposals which were issued in February 2012 in the form of non-binding automated trading guidelines to ensure proper testing, maintenance and regulatory oversight of algorithms. The MiFID II Rapporteur, Markus Ferber MEP, has said that, in his view, there must be clear rules on high frequency trading, so as to curb speculation without harming the real economy. He is also keen to make the advantages of high frequency trading more visible while avoiding potential negative consequences such as a flash crash, seeking to balance the benefits and potential challenges stemming from high frequency trading. His draft of MiFID II seeks to impose a compulsory 500 millisecond resting time on orders and a ban on market taker pricing.
In the UK, most recently, the House of Commons Business, Innovation and Skills select committee has, in its report (see Report: The Kay Review of UK equity markets and long–term decision making), recommended that the government ‘consider the viability, benefits and risks of an FTT on HFT’ but recognised that additional research is needed to assess the impact of a FTT on equities trading generally and likelihood of trading activities moving offshore.
As mentioned above, France also introduced a separate levy on HFTs. It remains to be seen what the impact of the approach will be in France (and Italy).
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