Exchanges: time for a rebuild?

On 3 January, just three days into the New Year, US exchange Nasdaq reported that it was investigating a problem with the data feeds for its Universal Trading Platform.

The outage lasted around 10 minutes, and affected users viewing consolidated tape C, a public utility provided by the DTCC using data collected from US exchanges including Nasdaq. During that period, investors were unable to view Nasdaq-listed stocks.

Then on 10 January, US exchange operator BATS Global Markets admitted that it had uncovered a technical fault that may have caused it to accidentally breach best execution regulation on thousands of client transactions over a four-year period.

The technical problems at Nasdaq and BATS have reinforced the impression among many market observers that there may be something seriously wrong with equity market structure. Recent history reads like a catalogue of disaster for many of the world’s most prominent trading venues. In February 2011, the London Stock Exchange experienced a series of crashes, including an incident where trading was halted for four hours, as it attempted to migrate to its new MillenniumIT trading engine. In March 2012, BATS was forced to cancel its own IPO after a trading glitch caused shares to collapse to less than a cent in value in seconds. Then in May 2012, Nasdaq suffered an embarrassing trading malfunction during the IPO of Facebook, which left investors unable to see whether their transactions had gone ahead.

“This all adds to the general sense that markets are under-regulated and technology has got out of hand,” said Paul Squires, head of trading at AXA Investment Managers in London.

 The race for pace

Many institutional investors argue that the problem stems from the obsession many exchanges and trading venues have had over the last few years with boosting profits by making themselves more attractive to high-frequency traders. HFTs typically boost trading volumes, leading to more fees for the exchange to collect. Senior industry participants such as Tony Mackay, founder of Chi-X Europe, have argued that excessive focus on speed has harmed the integrity of equity markets, as exchanges have stripped out much of the functionality on which longer-term institutional traders used to rely for the sake of greater speed.

“The BATS issue just sums up the problems with the arms race to technology that has caused so many problems for traditional investors,” Adrian Fitzpatrick, head of investment dealing at Kames Capital, told Banking Technology. “If I wanted to play Xbox all day I would stay at home. Regulators need to realise what the market is for and from my perspective it should be for institutions not HFT.”

However, not everyone agrees that exchange outages are more common today than previously. According to Frederic Ponzo, managing partner at capital markets consultancy GreySpark Partners, the issue is not so much that exchange outages happen more often now than in the past, but that the fragmented structure of equity markets, in which tens of alternative trading systems, dark pools and broker crossing networks compete with each other for order flow, all relies on primary exchanges for price formation.

“The problem here is twofold,” he said. “We are missing the regulation we need on market resilience, and secondly when the reference market goes down, the entire system of alternative marketplaces collapses because there is no alternative for price discovery.”

Alternative markets such as BATS Europe take the prices formed at the primary exchange as their starting point, as they do not have listings businesses of their own. The same is true of dark pools and broker crossing networks, which typically use a reference price derived from the main exchanges.

“When the system crashes, it hurts a lot more, because the entire marketplace is more fragile,” added Ponzo. “There’s nothing in the rules for trading platforms about market resilience, and that is an issue.”

Regulators in the US and Europe have been particularly concerned with market stability since the flash crash of 10 May 2010, in which $1 trillion was briefly wiped from the value of the US stock market. The crash was blamed on an erroneous order, which was then picked up by algorithms which fed off each other to create the crash.

In June 2012, the US Securities and Exchange Commission approved proposals to replace the US’ existing single stock circuit breaker safety net with a system in which the entire market can be temporarily suspended, to alleviate the effect of unusually large sudden price movements. However, some buy-side market participants have questioned the move, suggesting that to prevent price formation during a moment of market stress could stop the market from achieving equilibrium, and may even exacerbate volatility when the market reopens.

Divisive medicine

In Europe, much of the market structure debate has come to centre on the role of HFT and how it affects longer-term investors, who are typically identified with the real economy. Italy’s Borsa Italiana introduced a scheme last April that charges HFTs that exceed an order-to-cancel ratio of 1:100. The aim is to cut down on the amount of ‘noise’ they generate by making it more expensive to cancel too many orders. In France, the introduction of a unilateral financial transaction tax has made it less profitable for HFTs to enter and exit the market based on tiny price differences; senior politicians, including the country’s finance minister, have also called for an outright ban on HFT.

Meanwhile, as Banking Technology was closing for press, the German parliament was considering its own legislation that would impose tougher controls on HFT, including a registration requirement, minimum tick size rules, and an obligation to submit algorithms and trading strategies to the regulator. The German move was met with cautious approval by buy-side market participants, who argue that action is needed to redress the balance between HFT and longer-term investors.

“All we want is a level playing field,” said Fitzpatrick. “Currently the market is skewed towards HFT. The regulators need to decide who and what the market is for – a playground for HFT, or a genuine market place for retail and institutional investors.”

MiFID II, the European Commission legislation that will set out the rules for securities trading across Europe, currently contains proposals intended to hit HFT, including a minimum order resting time, as well as an obligation for market makers to provide continuous liquidity regardless of market conditions

Both moves have been criticised by market participants, who argue that the former would simply make it even easier for HFTs to target institutional flows, while the latter would effectively drive many HFTs from the market, with severe adverse effects on liquidity.

Other senior buy-side representatives have also expressed some concerns about liquidity. “The increased governance is unsurprising and welcome, particularly in highlighting the order to trade ratio,” said Squires at AXA Investment Managers. “It shows that some regulators are not prepared to wait for the tri-partite MiFID II process to reach any conclusions before implementing their own national directives on some issues like HFT. The downside is that it is further squeezing liquidity – HFTs account for around 40% of European volumes. European equity trading volumes have fallen from €1.4 trillion in January 2008 to just €485.5 billion in December 2012, according to figures provided by Thomson Reuters equity market share reporter.

Debates have also raged over the extent to which regulators should get involved – and whether re-adjusting the market to penalise HFTs and favour long-term investors would provide a lasting solution to the market structure problem. According to GreySpark’s Ponzo, while exchanges have cut corners to provide for HFTs at the expense of the longer-term investor, a competitive market structure should still negate the need for regulation, since alternative providers are free to set up services that provide for under-served sectors of the market, such as long-term investors.

Citing Eos Airlines, which ran a business-class only airline service in the mid-2000s, Ponzo suggested that HFT was the equivalent of the economy class passenger who might not drink the complimentary champagne, but was still legitimately entitled to use the service. The lesson for equity markets, he added, was that specialisation of trading venues, some towards the high-end long-term investor and some towards the HFT, was a better solution than a monopolistic market structure.

“Different venues have different roles,” he said. “For example, BATS is the cheapest – it’s the Ryanair of trading. It gets you from A to B cheaply, and that is a useful service. In response, exchanges like the LSE have cut costs to pursue that ‘economy class’ HFT part of the market. But some customers want to fly business class, and those customers are moving to other venues that provide a more high-end service. There is nothing wrong with that.”

Keeping watch

Other observers worry that the lack of tools to maintain surveillance over fragmented capital markets could be endangering investors. Speaking during a panel discussion hosted by SunGard in January, Richard Gardiner, policy advisor at the Federation of European Securities Exchanges warned that market abuse could be taking place undetected, due to the difficulty of tracking activity spread across multiple exchanges or trading venues.

“There’s no single person checking for abuse in particular names over five or six venues,” he said. “This needs to be looked at. Right now, even if you think there is abuse taking place, there’s no way to get the data to prove it.”

Part of the difficulty is the lack of a consolidated tape of post-trade data in Europe. In the US, post-trade data is provided in real-time as a public utility by the DTCC, but in Europe no comparable service exists to provide a complete view of market activity at a cost affordable to the mainstream consumer. In November last year, BATS Chi-X Europe chief executive Mark Hemsley said that the original MiFID had failed to provide the full benefits anticipated, and criticised “vested interests” at the primary exchanges for holding up the creation of a consolidated tape because of the threat it posed to their profits from market data.

The European Commission’s upcoming MiFID II does support the creation of a consolidated tape, but the draft document leaves it open to a public tender process, rather than setting a specific provider – a measure that has been met with disappointment in some circles. In late November, an industry initiative called the COBA Project published an open letter to the industry, calling for the creation of a consolidated tape by Q2 2013. Meanwhile, FIX Protocol has published its own set of guidelines that focus on the standards that could be used to build the tape. The FPL suggestions include the introduction of standards to identify where a trade was issued and in which currency, on which trading venue or exchange the order was executed, and the time the trade was executed and reported, expressed to the nearest millisecond, or if available, microsecond.

“We need more surveillance,” said Christina Ploom, risk analyst at Swedish government body Finansinspektionen. “Everyone talks about the possibility of market abuse, but nobody has a full picture. I can’t emphasise enough how important this issue is to a stable, effective market structure.”