High-frequency trading, dark pools and flash crashes have become part of the trading world's lexicon and are now within the radar of regulators. Nicholas Pratt examines what kind of regulatory response buy-side heads of trading would prefer.
By the end of 2011, Hollywood will have produced more sequels than in any other year (27), such as Harry Potter and the Deathly Hallows Part Two, Sherlock Holmes: The Book of Shadows, and Kung Fu Panda II. Rivalling these cinematic efforts for drama and suspense will be the rule-makers and regulators of Europe’s financial markets who are hard at work penning their long-awaited sequel to the Markets in Financial Instruments Directive (MiFID), an edict released in 2007 to a mixed reception from the critics.
The European Commission’s review of MiFID should result in an approved text – dubbed MiFID II – in time for the summer.
Much has happened since 2007 that the MiFID review has endeavoured to accommodate. These include amendments to the original directive where market changes have not quite worked, as well as factoring in the growing influence of electronic trading, particularly the high-frequency, algorithmic-based variety, and the general regulatory desire to reform the derivatives market.
The EC also wants a more consistent approach to its implementation. Individual member states such as Spain are still yet to fully realise MiFID.
MiFID II will undoubtedly affect all market participants to some degree. For asset managers, and for their heads of dealing particularly, the challenge lies in assessing just how important all the directive’s changes will be and how best to influence its producers before the final cut is completed.
Kevin Cronin, head of equity trading at Invesco, says that any regulatory developments must focus on the interests of institutional investors first and foremost. “Regulators need to understand that institutions represent the interests of the individual investor. The evolution of the hunt for liquidity has made trading an essential part of the investment process. As such, markets need to be efficient, fair and transparent and regulators should be grounded in these principles.”
At the industry’s TradeTech conference in London last month, David Lawton, head of markets infrastructure and policy at the UK’s Financial Services Authority (FSA), mentioned a number of specific steps it would be advising the EC to take when setting out its new regulatory framework.
These include the defining of different trading venues. MiFID currently recognises three different types: regulated markets (the exchanges), multilateral trading facilities (such as Chi-X and Bats), and systematic internalisers (where investment firms deal on their own accounts in an organised and frequent basis).
The EU has proposed that all other organised trading be classified under a new organised trading facility (OTF) category, except for any trading that can be defined as purely over-the-counter. While the EC has made room for further sub-categories within the OTF classification – such as broker crossing network (BCN) – its scope remains very broad. This is a concern among both market participants and the FSA. Lawton said at the conference: “There is significant risk that [the OTF classification] will capture forms of trading that are not truly organised or venue-like.” He referred to the example of a bulletin board which, while allowing prices to be displayed by dealers to initiate bilateral trades, provides no facility for execution.
The other area where definitions are likely to play a crucial role concerns high-frequency trading. The FSA proposes that traders above a specified minimum threshold and direct members of a trading venue should be authorised and required to make continuous quotes in the instruments they trade. And platforms would be required to ensure that orders on their markets rest in place for a given period before being cancelled, or that participants do not submit more than a given ratio of orders to actual trades.
The FSA does not, however, believe that high-frequency trading firms should be subjected to a provision of liquidity, believing this might deter them from entering the market.
Similarly, the FSA does not believe high-frequency trading orders should not be made to rest on the book for a minimum period of time, adding: “Any participant may wish to delete an order quickly for prudential reasons and forcing participants to remain in the market could damage overall market efficiency and compromise firms’ risk management.”
No great anxiety
For many heads of dealing, the FSA’s approach, particularly the proposal to remove the OTF classification and create a BCN classification, is welcome in that it is attempting to address a potential problem without being too prescriptive.
“Among our portfolio managers there is an awareness of high-frequency trading, but no great anxiety,” says Paul Squires, head of trading at Axa Investment Managers. “Nevertheless, we do need some rules in this area. High-frequency trading has made some significant changes to the market in terms of structure, volume and new entrants, and regulators should recognise that. The problem is ascertaining exactly where high-frequency trading becomes toxic and, therefore, we have to be careful about applying broad definitions.”
Tim Rowe, manager, trading platforms and settlement policy, markets division at the FSA, shares Squires’s concern over the lack of definition among high-frequency traders and also the lack of data to verify just how widespread high-frequency trading is in the market. Esma (European Securities and Markets Authority) has consequently sent out questionnaires to trading firms and is currently looking at the responses, which, says Rowe, have been “fascinatingly diverse” due to the fact that high-frequency trading is such a broad term. “We would like to issue a consultation paper based on the findings from the questionnaires, but the first thing we need is a definition of high-frequency trading – is it a holding period of six seconds or less, or is it any trade completed within the hour?”
The main point of interest for buy-side dealers, however, remains trade reporting and the issue of consolidated tape for Europe. One concern that Squires has is the fact that the term “consolidated tape” is used by many but perhaps not fully understood by all. “You have to make the distinction between pre- and post-trade transparency. In this respect I think the level of pre-trade transparency we have is already sufficient. The focus, therefore, should be on the post-trade data, more specifically on deciding the extent of and the rules governing trade capture.
“On the matter of whether brokers should report ‘risk’ trades immediately, we would be concerned that what is an important choice of execution for us would be diminished. But we don’t want to excessively protect brokers from the overriding need to be transparent. We need a pragmatic, tiered approach to volume thresholds and trade sizes,” says Squires.
Fortunately, the FSA appears to echo these concerns. Having more transparency around non-equity instruments makes sense as does improving the quality and standards of post-trade tape, says Rowe. “The importance is in the detail and ensuring that the right structure is in place and the cost is right. For example, we should only collect transaction reports where it is useful for spotting market abuse because it is a costly exercise.”
The FSA hopes to publish new proposals for transaction reporting in July. Its challenge in the interim, as for all other supervision, is striking a balance between robust regulation and a flexible framework, according to Carl James, global head of fixed income and FX at BNP Paribas Investment Partners.
James cites Laffer’s Curve, an economic model of taxation that was popular in the Reagan era [1981-89] and is regularly used as a warning against excessive levels of income tax – just as charging 0% income tax will bring in no tax revenue, charging 100% income tax will produce the same result because no one will go out to work.
The wish for proportionality also summarises the feeling of fund managers’ clients when it comes to regulation, says James. Best execution, dark liquidity and MiFID II are not at the top of their priority list. “Primarily, they want to know how much money they are making. However, when it does come to regulation, they want to know that we have a structure in place in terms of technology and governance and people and that we are engaging with regulators. They want effective and efficient execution and they want evidence of it. But they do not want to pay too much for it.”
©2011 funds europe