Do today’s markets lack resiliency?

Traders' View of the World

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Global volume of exchange-traded derivatives approached 25 billion in 2011, largely on the strength of high-frequency trading (HFT). Most exchanges expect that trend to continue, and are ramping up their trade-matching engines to accommodate it. For example, come December, Eurex will be running on the super-fast Optimise engine developed by its International Securities Exchange (ISE) subsidiary.

But market participants and end-users alike are losing their enthusiasm for HFT, and the overall futures terrain is littered with the detritus of the MF Global debacle and the lingering effects of both the 2008 financial crisis and the 2010 flash crash.

All of these issues might best be understood as part of a larger debate over the relative merits of efficiency and resiliency. It’s a debate that former JP Morgan Managing Director John Fullerton laid out for us in February in “The Financial Transaction Tax: Panacea, Pathogen, or Just a Bitter Pill?

“Basically, efficiency is the ability of a system to grow and expand and process throughput, while resiliency is the ability of a system to recover from a shock,” Fullerton said. “Economics has tended to focus on maximizing efficiency, but resiliency is only now getting widespread attention.”

He was speaking in defense of a proposed financial transaction tax (FTT), which would tax a small portion of every trade to support regulators or simply reduce speculation, but the subtext has been evident everywhere this past year — even on panels at the World Economic Forum in Davos, Switzerland. There, two former central bankers (one-time European Central Bank boss Jean-Claude Trichet and one-time Mexican central bank governor Guillermo Ortiz) joined the current head of the UK Financial services Authority Adair Turner in questioning the value of HFT. 

“The acid test here is to ask yourself whether new products and innovation [are] something that benefit directly or indirectly the real sector of the economy, the households,” said Ortiz. “Does it help to better allocate resources, does it help distribute risk better, or are we just talking about bets that are being taken in the financial sector and have nothing to do with the real economy?”

Turner agreed — and reminded participants that regulators are fully aware of the benefits that HFT theoretically delivers in terms of liquidity, but wondered aloud whether we may have gone too far.

“We know from the efficient-market hypothesis that the more markets you have, the more allocative efficiency there will be, the more risk will be shared, the better price discovery we will have,” he said. “But once you’ve got a reasonably active, liquid market, is there any real value? It’s quite reasonable of us to ask searching questions in a way we didn’t before the crisis on whether this is limitlessly good.”

In February, the Swedish regulatory agency Finansinspektionen (FI) issued a long-awaited report on HFT that concluded the practice is mostly harmless — not a condemnation, but hardly a ringing endorsement. 

Then, in March, we saw the release of the “Interim Review of UK Equity Markets and Long-Term Decision Making.” Coordinated by London School of Economics Professor John Kay, the report is based on a survey of British asset managers, pension funds and corporate treasurers — most of whom, it turns out, doubt that HFT even makes markets more liquid, let alone whether it has any real benefit to the larger economy. 

“The purposes of equity markets are to generate returns for savers and to improve the performance of companies,” wrote Kay. “Many respondents to this Review thought that equity markets have lost sight of these goals.”

The Association of Chartered Certified Accountants (ACCA) was one such respondent. 

“It is sometimes forgotten that equity markets exist not solely to enrich speculators, market makers and intermediaries,” said the ACCA in its official response. “It would seem fair to say that equity markets today serve the needs of the players in these markets better than they serve either those who put up the money or the businesses.”

It’s not just HFT that came under fire, but the entire concept of fostering competition among equities platforms, which has resulted in fragmented platforms synchronized by high-frequency arbitrage.

“In a number of discussions, participants… expressed the regret that the older model — in which the exchange was a utility, existing to serve the needs of market participants in the first instance and then the economy more generally — had been displaced by one in which exchange services were a standalone business,” Kay wrote.

One thing everyone agrees on is that some HFTs are gunking up the system by flooding it with scores of orders for every executed trade. U.S. Securities and Exchange Commission (SEC) Chairman Mary Schapiro wants to implement a fee on companies that generate high “order-to-trade” ratios — something that exchanges already are doing on their own. The Intercontinental Exchange (ICE) has implemented a more complicated “high-frequency messaging policy” that combines ratios with the distance of orders from the market. 

Volcker veracity and other rules

In late February, the SEC closed out the comment period on the Volcker Rule, which will be phased in over two years starting this July. That’s the rule that says any banks getting federal deposit insurance shouldn’t be allowed to trade certain products for their own accounts under certain circumstances.

The SEC received more than 16,000 comments, more than 90% of which are in favor of the rule. 

Meanwhile, the Commodity Futures Trading Commission (CFTC) voted to adopt more than 50 new rules mandating risk-management policies and reducing conflicts of interest for swaps dealers as part of the great migration to exchanges.

CME Group is on the hot seat over its regulatory oversight in the MF Global affair and the Chicago Board Options Exchange’s (CBOE) regulatory role also is being examined. The SEC, the CFTC and local authorities all have questioned both exchanges’ oversight of the company.

Neither exchange is accused of wrongdoing and these types of reviews are standard following a crisis, but the failure has raised a question on whether for-profit exchanges — in their pursuit of HFT volume — are conflicted as self-regulatory organizations (SRO).

The CFTC has been holding roundtables on how to close out the MF Global debacle and prevent something similar from happening in the future, and most of the proposals are fairly common-sense — from more aggressively pursuing criminal charges (or at least keeping closer tabs on the whereabouts of customer segregated funds), to establishing an industry-wide fund to reimburse victims to requiring more managers like Jon Corzine to personally sign off on hundred-million-dollar money transfers. 

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Wrangling for exchanges

The European Union’s Competition Commission may have blocked the $10 billion merger of Eurex parent Deutsche Börse and NYSE-Euronext, but that hasn’t stopped NYSE-Euronext from battling with the London Stock Exchange (LSE) and at least two other suitors over LCH.Clearnet — one of two bidding wars underway in London.

The other is the scramble to buy the 135-year-old London Metal Exchange (LME) — whose trading ring is one of Europe’s last open-outcry trading floors. The LME is mum on details, but ICE, CME, NYSE-Euronext, Shanghai Futures Exchange and Singapore Exchange have been mentioned as potential suitors.

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