Algorithmic Trading in Commodity Derivatives: Overview of UK and EU Regimes

Overview

Algorithmic trading has been used in the financial markets for years and is highly regulated. The regulatory framework governing algorithmic trading was established by 2014 amendments to Markets in Financial Instruments Directive (MiFID II) and has been applicable since 2018, both in the United Kingdom (UK) and in the European Union (EU). In recent years adoption of algorithmic and high-frequency trading techniques has spilled over to the commodity markets, with market participants more frequently adopting various forms of trading technology in their day-to-day business. The purpose of this note is to explain the UK and EU regulatory frameworks applicable to algorithmic trading in commodity derivatives and wholesale energy products.

MiFID II and the regulation of algorithmic and high frequency trading in financial markets

What is algorithmic trading?

The regulatory framework for algorithmic trading was originally developed via amendments to MiFID II, setting a harmonised framework governing algorithmic and high-frequency trading across EU Member States. As the UK was part of the block at the time, the MiFID II provisions were duly transposed to its national legal framework. Consequently, algorithmic trading is regulated in the UK under the Financial Services and Markets Act 2000 (Markets in Financial Instruments) Regulations 2017 (MiFI Regulations), Article 2(1) of which 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). Algorithmic trading does not encompass systems that are only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions. The same definition remains applicable under EU MiFID II.

What is high frequency algorithmic trading (HFT)?

HFT is a sub-category of algorithmic trading, but importantly, not all algorithmic trading qualifies as HFT. In the UK, HFT is defined under Article 2(10) of the MiFI Regulations as an algorithmic trading technique characterised by:

1. infrastructure intended to minimise network and other types of latencies, including at least one of the following facilities for algorithmic order entry: co-location, proximity hosting, or high-speed direct electronic access (these being the conditions aiming to test the distance between a firm’s server and the trading venue’s matching engine);
2. system-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders; and
3. high message intraday rates which constitute orders, quotes or cancellations. Secondary legislation specifies that a high message intraday rate for the purposes of the definition of HFT means on average at least 2 messages per second with respect to any single financial instrument traded on a trading venue or at least 4 messages per second with respect to all financial instruments traded on a trading venue.

Akin to the definition of algorithmic trading, the definition of HFT stems from the MiFID II framework and remains the same in the EU. 

Consequences of engaging in high frequency algorithmic trading

There are consequences under both the UK and the EU legislative frameworks of using an algorithmic or HFT technique. The most relevant consequence of engaging in HFT for firms trading in commodity derivatives, emission allowances or derivatives thereof is that they may no longer qualify for the ancillary activity exemption (AAE)¹. By way of reminder, the AAE applies where a person:

1. deals in commodity derivatives, emission allowances or derivatives on emission allowances (AAE instruments) on own account (not to execute client orders); or
2. provides investment services other than dealing on own account in commodity derivatives, emission allowances or their derivatives, to customers and suppliers of its main business,

provided that, in each case, the activity considered individually and in aggregate is ancillary to the person’s main business when considered on a group basis and in accordance with a series of tests. HFT, being a trading technique requiring sophisticated infrastructure is considered a feature of a firm which is not just trading in financial instruments on an ancillary basis, hence its exclusion for the AAE exemption. In practice therefore, only investment firms engage in HFT trading.

Consequences of engaging in algorithmic trading

The situation is slightly different in case of the algorithmic trading. Importantly from the perspective of commodities markets participants, this type of trading does not disqualify a person from eligibility to rely on the AAE, all other conditions of the exemption being met. Also, whilst the currently applicable UK and EU MiFID II framework regulates engagement in algorithmic trading by investment firms, it does not apply to exempt persons. From a regulatory perspective and in light of the “same activity – same risk – same regulation” principle, this arguably creates a diverse treatment between different categories of market participants.

For regulated investment firms in the UK, the requirements relating to algorithmic trading under Article 17 of MiFID II were transposed into UK law under Chapter 7A of the FCA’s Market Conduct Sourcebook (“MAR”). An investment firm, or a third country investment firm with an establishment in the UK, that engages in algorithmic trading must ensure that trading systems must:

1. be resilient and have enough capacity;
2. be subject to appropriate trading thresholds and limits;
3. prevent the sending of erroneous orders;
4. not function in a way that contributes to a disorderly market; and 
5. not be able to be used for any purpose that is contrary to the rules of a trading venue to which it is connected or MAR.²

Additionally, the firm must have effective business continuity arrangements to deal with system failure, ensure that trading systems are tested and monitored, and that records are sufficient for the FCA to monitor compliance.³

Investment firms that engage in algorithmic trading in the UK or an EEA state and are members or participants in a regulated market, EU regulated market, MTF, or OTF must immediately notify the FCA.⁴ MAR also requires firms to keep records that include: a description of the nature of their algorithmic trading strategies; details of the trading parameters or limits to which the trading system is subject; evidence that points (a) – (e), as well as the business continuity and systems tests mentioned above, are met; details of system testing; records of placed orders; and further information about its algorithmic trading and systems used for such trading.⁵

Similarly detailed requirements apply under the EU MiFID II framework to investment firms engaging in algorithmic trading.

EU REMIT and the extension of algorithmic trading regulation to wholesale energy markets

What is algorithmic trading?

The legislative framework governing trading in wholesale energy products in the UK and in the EU is included in the Regulation on Wholesale Energy Markets Integrity and Transparency (REMIT). Adopted originally in 2011 (and as such, applicable in the UK long before its departure from the EU), REMIT had not been subject to substantive review for over a decade, save for minor on-shoring post-Brexit adjustments made to the UK version of the legislation.

That was until the EU recently completed a comprehensive review of REMIT, with the amending legislation being published in the EU Official Journal in April 2024, and subsequently becoming applicable on a phased-in basis. One of the novelties introduced to the EU REMIT framework by the amending legislation was regulation of algorithmic trading in wholesale energy products. By way of reminder, following the review the scope of wholesale energy products in the EU includes:

• contracts for the supply of electricity, hydrogen or natural gas, including LNG, where delivery is in the Union, or contracts for the supply of electricity which may result in delivery in the Union as a result of single day-ahead and intraday coupling;
• derivatives relating to electricity, hydrogen or natural gas produced, traded or delivered in the Union, or derivatives relating to electricity which may result in delivery in the Union as a result of single day-ahead and intraday coupling;
• contracts relating to the transportation of electricity, hydrogen or natural gas in the Union;
• derivatives relating to the transportation of electricity, hydrogen or natural gas in the Union;
• contracts relating to the storage of electricity, hydrogen or natural gas in the Union; and
• derivatives relating to the storage of electricity, hydrogen or natural gas in the Union.

Similar to the UK and EU definitions of algorithmic trading under the MiFID II framework, EU REMIT II defines algorithmic trading as trading, including high-frequency trading, in wholesale energy products where a computer algorithm automatically determines individual parameters of orders to trade 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 human intervention or no such intervention at all, not including any system that is only used for the purpose of routing orders to one or more organised marketplaces or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions.

In its July 2024 Open Letter on Algorithmic Trading, the European Union Agency for the Cooperation of Energy Regulators (ACER) provided a non-exhaustive list of situations that fall within the scope of REMIT-regulated algorithmic trading.

In-scope:

1. Internal (market participant’s) algorithms: these are built in-house, tested on an OMP, and deployed as a tool 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.
2. External (OMPs’) “execution algorithms“ without human intervention: these are trading functionalities with automated management of orders. For example, orders that are executed through functionalities which, as well as routing orders to OMPs, offer automated management of the order (by, for instance, automatically redirecting unexecuted portions of such orders to other venues or slicing orders prior to execution). Therefore, algorithmic trading encompasses both the automatic generation of orders and the optimisation of order-execution processes (for example, slicing of orders) by automated means.
3. Stand-alone vendor algorithms by third parties: this includes all types of algorithms independent of their complexity (for example, PowerBot). 

Out of-scope:

1. External order types offered as standard functionalities by exchanges or OMPs: they are a standard way to interact with the market and are made available on a wide range of exchanges and execution platforms that do not contain further own dynamics apart from predefined parameters (for example. iceberg orders where the portion of orders is pre-defined and the slice doesn’t react or change when market conditions change, stop-limit orders, delayed orders). 
2. Systems used for the confirmation of orders or post-trade processing of executed transactions: these are not directly related to placing orders or executing transactions.
3. Signal generators: because they do not act in the market. It will still be a human trader who will have to check the information provided by the signal generator and, if the suggestion provided is agreeable, either place a manual trade or set up an algorithm to trade.
4. Systems for pure order routing: being systems which do not process any external parameters or market variables when forwarding orders in an automated way.

Consequences of engaging in algorithmic trading in wholesale energy products (EU)

Under EU REMIT, a market participant engaging in algorithmic trading is subject to two key obligations⁶:

1. the market participant must have in place effective systems and risk controls suitable to the business it operates to ensure that its trading systems are resilient and have sufficient capacity, are subject to appropriate trading thresholds and limits and prevent the sending of erroneous orders to trade or otherwise function in a way that may create or contribute to a disorderly market.
2. the market participant must, since May 7, 2024, notify their engagement in algorithmic trading to the national regulatory authority of the member state where it is registered and to ACER.

Additionally, the market participant must keep records of a description of the nature of its algorithmic trading strategies, details of the trading parameters or limits to which the trading system is subject, key compliance and risk controls and details of the testing of its trading systems for five years. These records are sufficient to enable the NRA to monitor compliance. In contrast to the MiFID framework, REMIT does not set out detailed operational and technical requirements for market participants engaging in algorithmic trading in wholesale energy products. In the absence of any prescriptive requirements, the regulators are likely to expect similar types of systems, arrangements and controls in REMIT market participants as those required under the MiFID II framework.

REMIT mandates ACER to issue guidelines and recommendations on a number of issues, including on the provisions on algorithmic trading. That said, there are no specific timeframes concerning development of such guidelines and recommendations. 

Consequences of engaging in algorithmic trading in wholesale energy products (UK)

UK REMIT is the retained EU law as originally adopted in 2011. Consequently, the UK REMIT does not reflect the EU REMIT changes made in May 2024, which brought the algorithmic trading requirements into play. At the time of writing, we have seen no formal indication that the UK will implement the same EU revised REMIT requirements.