Slowing down high frequency trading
Speed limits would cool high frequency trading (HFT) that has created destabilising effects on liquidity and price formation, according to Andrew Haldane, Executive Director for Financial Stability at the Bank of England.
In a speech at the International Economic Association Sixteenth World Congress in Beijing, Haldane outlined how dramatic shifts in the structure and speed of trading have increased abnormalities in the pricing of securities. This new trading environment has potentially increased systemic risk, but so has the fragmented regulatory framework globally. Technology is now as much a part of the fabric of financial markets’ microstructure as the regulatory framework.
Market participants are competing heavily to benefit from small changes in price, building up sophisticated computer and communication systems to execute low-latency algorithmic trading strategies. While the commoditisation of technology may level the playing field in time, as the situation is currently less sophisticated traders may withdraw from the market rather than risk being gamed by firms that use faster technology.
Haldane’s proposal of imposing speed limits would raise bid-ask spreads on average, but should volatile market trades, especially in stressful market conditions. Minimum resting periods are being discussed both in the EU and United States but are facing stiff opposition from dealers who argue this would make markets less liquid and efficient. Haldane dismisses these arguments, saying it would improve resilience in liquidity during times of stress. He believes that the balance between stability and efficiency should be tilted in favour of the former objective, in light of the recent financial crisis.
The trade-off between efficiency and market integrity is further discussed by the Technical Committee of the International Organisation of Securities Commissions (IOSCO), in a recent consultation on regulatory issues associated with the advances in technology.
IOSCO notes that technology in financial markets has resulted in countless benefits for regulators and market participants, from reducing transaction times, generating audit trails, enhancing order and trade transparency, to helping market participants develop and apply automated risk controls. However, it has also generated risks, in particular risks of contagion.
The Flash Crash of 6 May 2010 — which saw US-based equity products experiencing an extraordinarily decline and recovery in the space of minutes — brought home vividly to regulators the dangers of technological advancements, coming closely on the heels of the financial crisis. According to the federal agencies which investigated the crash, in deteriorating market conditions, the interaction between automated execution and algorithmic trading strategies may
erode liquidity and destabilise markets. Algorithms programmed to operate on a cross-market basis (which are not as prevalent in Europe) may increase and exacerbate the speed at which systemic crises develop as shocks are transmitted rapidly from one market to another. IOSCO also notes the dangers of algorithms which operate in an unintended way, “triggering a chain reaction” which, in stressed market conditions, can result in large outflows of liquidity from the market.
Reacting to these events (amongst other things), the European Commission consulted on a range of possible measures on automated and high frequency trading as part of its December 2010 consultation on the revision of the Markets in Financial Instruments Directive (MiFID II)
. Its proposals include many requirements which are similar to Haldane’s suggestions:
- high frequency traders to give liquidity to markets on a mandatory basis;
- placing a limit on order to execution ratios; and
- introducing a mandated minimum resting times for orders submitted to order books.
IOSCO proposes a number of other regulatory actions to mitigate the risk of high frequency trading from specific stress testing and sign-off processes for new algorithms, to specific charges or a tax on high order entry or cancellations rates.
Legislative proposals on MiFID II are expected in October 2011, with a view to getting them on the statute books as early as possible, perhaps as early as 2013. Consultation on IOSCO’s paper on technology change in financial markets is scheduled to close on 12 August 2011.
Regulators recognise that they are struggling to keep up with the pace of technological developments, however, the recent push towards a regulatory framework for automated trading, particularly high frequency trading, suggest they may be catching up or, alternatively, slowing technology down.
Insurance Supervisors propose a global regulatory framework
On 6 July 2011 the International Association of Insurance Supervisors (IAIS) published a further consultation paper outlining a Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame) which is expected to be in place by 1 July 2013.
ComFrame has three main objectives, namely to:
- Develop a methodology for operating group-wide supervision of international insurance firms;
- Establish a supervisory framework to address group-wide activities; and
- Harmonise regulatory and supervisory measures and approaches.
The IAIS believes a comprehensive set of supervisory standards and measures is necessary to address group-wide activities and risks and also establish mechanisms for better supervisory cooperation in the future. The framework will set the parameters for the supervision of internationally active insurance groups, resulting in more effective supervision that is reflective of actual business practices. It will facilitate much more information and knowledge sharing between authorities and international insurance firms.
Some have questioned the need for ComFrame. However, IAIS contends that, despite the apparent healthy state of the global insurance sector, a common framework is necessary, as the insurance industry continues its transition from a multi-domestic industry to an international one. More and more insurance firms are engaging in activities across multiple jurisdictions. They want to achieve commercial synergies by pooling or transferring risks across national boundaries. In many regions, however, regulation and supervision has remained nationalistic, focusing on solo supervision, with limited progress made in the direction of group supervision. Europe is a good example of a region which has had group supervision for the past decade, resulting in more cross-board activity and a reduction in compliance costs for industry participants.
While many of ComFrame’s elements are “not yet harmonised in their approach and presentation” it does represents a good first milestone in creating group-wide supervision in the insurance industry. Peter Braumüller, chairman of the IAIS executive committee, outlined that the new framework, “will not only enhance the effectiveness and efficiency of supervision of these groups, but also contribute to our continuing efforts towards stability in insurance markets around the world”.
ComFrame will be outcome-focused. Technical standards underpinning the framework will be accompanied with required parameters and specifications to monitor the unique challenges facing national regulators. It is built on several modules; including risk management, group structure and business mix, qualitative and quantitative requirements, supervisory processes, minimum criteria requirements for individual jurisdictions. From 1 July 2011, IAIS started drafting specifications associated with these modules with relevant criteria to operationalise the requirements and objectives of the group-wide framework. It expects the framework to be completed within three years.
European Security Markets Authority (ESMA) takes action to protect retail investors
ESMA will take actions to warn investors about certain products, or ban them outright, if national regulators fail to take action to sufficiently protect retail investors, according to the Chairman of ESMA, Steven Maijoor.
Speaking to the EUROPLACE Financial Forum in Paris, Maijoor warned the industry that selling unsuitable products to investors is counterproductive, as short terms gains will be followed by retail investors ultimately turning their backs on the industry. The damage associated with recent financial crisis, where some retail customers lost huge sums of money investing in products they believed to be safe, has “not [yet] been repaired”.
Recent research by the European Commission concludes that the market for investments, pensions and securities is one of the three markets most likely to fail consumers. ESMA are keen to evolve a consolidated EU supervisory and regulatory approach towards investor protection, aimed at restoring investor confidence. Maijoor suggested that the measures already put in place in Europe to enhance the protection of retail investors are designed to improve compliance with current measures and have limited impacts in terms of additional costs to industry.