New rules to overhaul financial market regulation across Europe finalized in the European Parliament and Council late Tuesday could dramatically reshape the trading landscape, but questions regarding certain loopholes persist.

New EU Trading Rules Are A Game-Changer

The new rules were a response to the 2008 stock market crash caused largely by unregulated over the counter (OTC) derivatives and the 2010 “flash crash,” which was attributed to the domino effect from a large volume “fat finger” stock sell order that triggered additional high frequency trading algorithms to sell stocks, which in turn caused electronic market maker’s computer algorithms to withdraw from markets, temporarily leaving mostly sellers and few buyers.

OTC problems addressed

Among the most pressing residual problems from the 2008 market crash were unregulated derivatives.  These “insurance” like contracts were individually negotiated between two counterparties and traded off exchange.  The result was a lack of transparency and standardization, leading to investors not really understanding the true content of the investment products sold.  Conversely, when derivatives are traded on an exchange, the core principle is that the product specifications are known and understood by both parties, there is open price competition and the overall size and volume of the derivatives liabilities are known to regulators and the public.

The new EU deal

The new EU deal, which updates the Markets in Financial Instruments Directive (MiFid), is most significant in that the law is designed to tighten regulation on “dark pools,” off-exchange markets typically operated by large banks and hedge funds where product pricing is not publicly known.  To liquidate trades buyers and sellers typically engage in what is known as a “call around market,” where they literally pick up the phone to get pricing and execute trades.  During a crisis this can sometimes lead to difficulty exiting markets, as was the case with JPMorgan Chase & Co. (NYSE:JPM)’s now infamous “London Whale” trades.  Under the new rules, most trading previously done off exchange would now move on regulated venues.  The new EU deal also allows for financial companies to operate their own trading platforms but cannot use their own capital to trade on their platform.

Hours after the deal was signed some negotiators had raised concerns that loopholes could allow financial players to avoid regulatory oversight, according to a report in the Wall Street Journal.  Although the report does not specifically identify loopholes, the most significant loopholes have yet to be created.  Like Dodd-Frank, the exact technical details have yet to be negotiated.  The negotiation process in the EU is expected to take 9 to 12 months, unlike Dodd Frank which took years to negotiate after passing Congress and is still incomplete.

High frequency trading     

The new EU regulations seek to address high frequency trading issues head on in an attempt to avoid a repeat of the “flash crash.”  One of the key issues with the flash crash was computer algorithms pulling out when sell orders flooded electronic markets.  To combat this, new rules mandate that the electronic systems will not be allowed to shut down their offers to sell and bids to buy.  Further position limits that caps the size of a trader’s net holdings – a controversial issue in the US that has not been fully adopted – will be included in the new EU regulations, the details of which are still to be negotiated. Limits on using repetitive “rapid fire” sell algorithms, a tactic used by US high frequency traders identified in ValueWalk article as recently as last week, are prohibited under the new EU rules.

Issues HFT industry participants were keeping an eye on included crippling restrictions similar to the German HFT act in 2013, which forced many US HFT participants to exit the German market.  The German regulations required stiff registration requirements, trade restrictions and trade identification methodologies.  Another issue that HFT industry participants were concerned about was a minimum resting time provision that would mandate orders be required to sit in the market for half a second.  These restrictions were not included in the new regulations, nor were fines for violating certain order-to-trade ratios, another concern for HFT participants.

All told the new regulations are expected to come into full force in 2016.