Can you describe the SFC’s recent regulatory initiative on electronic trading? There’s a huge amount of work and thought being put into the regulatory approach to electronic trading internationally, and this effort has been underway for some time.
In Hong Kong, we published our new rules in March after a public consultation.
The initiatives are intended to provide much needed clarity to intermediaries and traders and, in common with much post-financial crisis regulation, are about safety, soundness and transparency. The rules are broadly in line with regulations across other major international markets and the principles published by the International Organization of Securities Commissions (IOSCO).
In essence, the rules apply to internet trading, Direct Market Access (DMA) and algorithmic trading, and are aimed at ensuring that undue risks are not borne by investors.
What are the comments of the industry on the new SFC regime of electronic trading? Feedback was pretty open and honest. There was no significant resistance to the proposals; it is pretty evident that sensible regulation is necessarily about system safety, testing, internal controls and the risks of DMA.
Of course some comments focused on the ever present tension between the extent of safety measures required to minimise risk to an acceptable level and the costs of those measures to the industry – and to end users.
For example, smaller firms were concerned about the extent they have to employ resources to check out an electronic system that is bought off-the-shelf. The answer is that you absolutely need to check it out – because if you don’t, the risks you are taking on are unknowable; you would be flying blind.
Although the new requirements will inevitably increase operating costs, we believe that the framework will actually facilitate the long-term growth of electronic trading in our market; electronic trading is here to stay and the regime ensures that investors are informed and can be confident. One thing we are very conscious of in Hong Kong is that we deal with a vast range of financial institutions from the very big to the very small. The impact of regulation on them, including electronic trading, can therefore vary, and that’s something we have to be sensitive to. Clearly, large firms may be better able to absorb additional costs than smaller firms.
With that in mind, the new regime will become effective on 1 January 2014 to allow sufficient time for all firms to implement internal control policies and procedures, as well as to make changes to their electronic trading and record keeping systems.
How are you examining dark liquidity? Fundamentally, with dark pools and dark liquidity, we are talking about trading off-exchange on platforms that do not offer pre-trade price transparency. Since the imposition of mandatory flagging of reported dark pool transactions by the Hong Kong stock exchange last year, the reported volume of trades executed in dark pools in Hong Kong has increased steadily, accounting for 2.2% to 2.5% of monthly turnover. This, of course, is very small compared to markets that have actively embraced alternative venues – and are now struggling with how to regulate them and find an optimal balance between the roles of “lit” and “dark” trading platforms.
We have identified a set of key issues concerning dark liquidity – clarity to users as to how a dark pool operates; involvement of retail investors; who within a financial institution can see what’s occurring in a dark pool; what ‘best execution’ means within dark pools; and proprietary orders within dark pools – e.g. the priority of proprietary orders versus genuine client orders.
So, unlike the new electronic trading rules – which are about firms operating between a trading platform and a client, this is a separate topic about the platforms themselves.
We’ve already come across some problems with existing dark pools. They have different configurations and different target clients, and of course they were originally developed to facilitate large trades by large institutions – but have moved on from this to deal with smaller trades. Those banks or brokers who operate their own “internal” dark pools tend to say that they are simply a benign electronic overlay to traditional brokerage operations. Exchanges counter this by saying that all trading needs to have pre-trade price and order book transparency and what the dark pools operators are doing is operating alternative exchanges, free riding on lit market pricing. To address these issues, we have actively discussed the situation with existing dark pool operators with a view to imposing carefully calibrated licensing conditions.
We will also consult the market later this year about codifying our stance to ensure a consistent, level playing field for all operators.
IOSCO Secretary General, David Wright, discusses the major factors influencing global markets, and the future of the global regulatory framework.
IOSCO is the International Organization of Securities Commissions. It brings together securities regulators the world over. We have 200 members representing the vast majority of regulators. Of all the international organisations covering financial regulation at the global level, we are the most inclusive because we have all the emerging market countries with us. This organisation has been running for 30 years and we have become the voice of the global securities regulatory community. For example, we have a series of global standards, what we call the IOSCO standards, which are the benchmarks for any securities market.
These standards form the foundation of all the reviews of financial regulation covered by the FSAP process led by the IMF. Our standards are the global benchmark. We have many interesting pieces of work right now; the multilateral memorandum of understanding, which about 90 of our members have signed, is basically a memorandum whereby all the participants agree to share information for enforcement purposes. The memorandum was used to solicit the exchange of information during the recent LIBOR scandal.
We have a lot of policy positions and we have a critical role in the whole process of global financial repair and reform. A lot of the work that you see referenced in the G20 or working with the Financial Stability Board is of IOSCO origin.
We have worked on high frequency trading, we work on shadow banking, OTC derivatives and credit rating agencies, we work on market structure, we work in accounting and auditing, enforcement and so forth. Of course, as a result of this crisis our work is particularly important. The other thing that we do, which is unlike other organisations, is that we provide technical assistance, and education and training for emerging market countries.
One of the things that we’re going to be working on is to build an IOSCO Foundation in which we seek support from the private sector to develop our members’ markets.
Should regulation be leading or following, who should decide what gets regulated, what gets left up to the market and to what extent do those forces interact?
Historically regulation has been following rather than leading. I think it’s right to say that this crisis shows that a significant number of incentives were wrong in the financial markets. I think the depth and scale of damage in this financial crisis, not in all parts of the world, but in certain parts of the world, show that serious repair is necessary, and that is the focus of the G20 and the Financial Stability Board agenda, which we are major contributors to.
The industry can’t complain, to the extent that they are primarily responsible for what happened, so there is a huge amount of work going on at the global level to try to make the financial system safer and less systematically risky. We are going to work on resolution and frameworks; we’re going to work on OTC derivatives, driving more OTC transactions onto exchanges, and through clearance systems. We are working intensively on the shadow banking system, which I think has surprised everybody with its scale, estimated at $65 trillion or 25% of all global banking assets, making that safer and more understandable; we are looking at money market funds, securitisation, and non-banking organisations, which can build up large amounts of leverage. Those are certainly among the most important areas of work, of course on top of bank capital, which is set by the Basel committee. The world has lost 15% of GDP so far; there are very serious worries of severe damage to certain economies and so we need very strong collective efforts at the local and global levels to try and put that right, and to try and make the system safer and more sustainable.
Are regulators struggling to keep up in terms of spending, and does this impact their oversight?
Regulators in general around the world always feel they are underresourced. When you look at the resources of one of the better resourced authorities, for example, the FSA, in London the FSA has over 3,000 people. But then you compare that to what used to be the head count of Citibank, which was 300,000 plus and that is just one organisation!
So when you multiply that across all the firms big and small they have to regulate and supervise, regulators in general feel underresourced. I think there are some good things happening though which may help them. For example the project being developed by the FSB called the Legal Entity Identifier which is a numbering system for all participants in financial markets. That I think would greatly simplify tracking market abuse, tracking data in markets, looking for systemic risk building up.
In general IT is helping the regulators detect market abuse, but there are huge markets to regulate and supervise. One of the problems has been particularly in the big complex markets, developed markets because, as has become clear, neither market participants nor the regulators or supervisors of those markets fully understood how they functioned.
We are now in year six of this crisis and we still are struggling our way through on the global regulatory level with the shadow banking system. Shadow banking is of enormous proportions, and we are still working it out. You can’t supervise or regulate a market unless you fully understand it.
I think that the one lesson of this crisis should be that unless you can fully understand not just the product, but how that product interacts, interconnects with other products, how risk can be propagated or, if things start to get difficult, what are the effects on liquidity etc, the effects on credit provision, and the effects on the system, then those products and processes should be held back until we are sure we understand.
Another area is measuring the impact of regulation; looking at the costs and benefits of regulatory change in highly interconnected complex markets, which is extremely difficult. Yet regulators should understand as far as they can the impact before calibrating final regulatory measures.
AFME’s Securities Trading Committee Chairman Stephen McGoldrick unlocks the latest MiFID proposals and looks at the rules for Organized Trading Facilities, algo trading and a consolidated tape.
Organized Trading Facilities (OTFs) The OTF regime began life as a specific regulatory wrapper to put around broker crossing systems, (which are a new mechanism for delivering an existing service). Crossing, which is almost the definition of a broker, has become highly automated. Whilst most crossing activities have not changed, other aspects of the industry were seen to require regulation – namely increased automation and greater scope of crossing. The initial proposals outlined an umbrella category of systems called OTFs, with one category created to hold broker crossing systems and another to hold the systems for G20 commitments around derivatives trading.
When the MiFID II proposals came out at the end of 2011, the ‘umbrella’ aspect had been simplified into a structure intended to be ‘all things to all people’, which is where it has come undone. MiFID II has created a regulatory receptacle for a practice and the two things differ in shape. The broker crossing system does not fit into the receptacle that has been created for it because much of the trading is against the books of the system’s operators, which is prohibited under the current proposals.
The regulators do not want speculative, proprietary trading within these systems, but unwinding risk created by clients is both useful and risk-reducing. An opt-in mechanism for compliance, allowing traders to decide if they want their orders traded this way may be a solution. Conflict management of this sort is common in the financial sector, as it ensures that any discretion is not exercised against the interests of the client. Certainly, when it comes to measuring the client’s interests against the operator of an OTF, it is absolutely unambiguous that their interests must come first. Therefore, any exercise of discretion that disadvantages the client relative to the operator is already prohibited. A formal, documented process to ensure that segregation stays in place is good, but to effectively prohibit the vast majority of trading on broker crossing systems seems to abandon the regulators’ objectives – to increase transparency and protect clients.
Furthermore, trades allowed into a broker crossing system would be instantly reported, creating post-trade transparency. The current proposals call for OTFs to be treated in the same way as Multilateral Trading Facilities (MTFs), which fosters uncertainty about the waivers for pre-trade transparency. Currently, there are clear criteria for granting a waiver to a platform: one is that orders are large in size, the other is taking reference prices from a third party platform. The Commission will not, however, be making the decisions about waivers; they have been handed to the European Securities Market Authority (ESMA) to determine. There is a danger in specifying too stringent limits for these waivers, which would create a very different landscape from that explicitly envisaged by MiFID I.
Systemic Internalisers (SIs) Our understanding is that regulators did not want to split activity that was in an OTF into two, but rather to regulate the broker crossing systems and to remove the subjectivity of SIs. The current SI proposal is aimed at regulating automated market making by banks, so that institutions make markets by reference to market conditions, not by reference to their clients. In MiFID I, the SI regime was introduced to protect retail investors, but subsequently this seems to have changed. When the European Commission (EC) was asked by the Committee of European Securities Regulators (CESR) to clarify the rationale for an SI regime, they declined to do so. As a result there is a distinct lack of clarity regarding the intent of the SI rules. If we had a clearer vision of the direction the regulators wished to take the market, then it would be far easier to assess whether the regulations were moving us in the right direction – or not.