MARKET REGULATION HAS been dominated by two primary concerns over the past couple of years: fear of the unknown effects of allowing trades to take place in the dark and concern about the very real risks that were revealed by the so-called “flash crash” in May 2010. Canadian regulators are still grappling with both.
The risks exposed in the flash crash – which saw markets in both Canada and the U.S. plunge without warning, then quickly recover, for no obvious reason – are most immediate. When trading becomes as volatile and incomprehensible as it did during that episode, investors are harmed and there’s an immediate loss of confidence in the markets. Regulators are still devising ways to guard against a repeat of that event.
Recently, the Investment Industry Regulatory Organization of Canada (IIROC) issued a consultation paper on the latest measure – volatility controls for marketplaces – that it is considering to protect against that sort of event. By requiring markets to set prices and volume thresholds, IIROC hopes to prevent so-called “fat finger” trades.
Mistakes, such as orders accidentally being placed for billions of shares, can wreak havoc on markets – particularly when there is a great deal of automated trading.
Some trading venues already have their own volatility controls designed to prevent these sorts of orders from reaching the market, but not all have them. And, for the ones that do, they don’t all work the same way. Regulators are now looking at standardizing price and volume thresholds to guard against wonky trades.
These controls are seen as one of four lines of defence against another flash crash – all of which are being introduced, or revised, in the wake of that 2010 event.
The first of four layers of security is the obligation that traders have to ensure that trading is carried out in compliance with the rules. Volatility controls that operate at the market level would form the next layer. And that is further backstopped by two types of circuit breakers that would kick in when trading activity gets wild, whether there’s a legitimate reason for it (such as a major news event) or not (a fat-finger trade).
In February, IIROC introduced single-stock circuit breakers (SSCBs) following a similar initiative launched in the U.S. This mechanism halts trading of a stock if its price moves by more than 10% in a five-minute period. Beyond that are the existing overall market circuit breakers, which can halt trading across all venues when the action becomes extreme and affects the entire market.
Although the marketwide circuit breakers weren’t triggered during the 2010 flash crash (in either Canada or the U.S.), IIROC reports that since SSCBs were introduced earlier this year, they have been triggered twice already.
In both cases, this was due to fat-finger trade orders being entered. And, the IIROC paper suggests, if there had been appropriate volatility controls in place, these mistakes could have been detected by the marketplace prior to execution.
Indeed, the IIROC paper indicates that the regulator doesn’t believe SSCBs should be the mechanism to prevent such mistakes. Although SSCBs may be expected to catch erroneous trades in rare cases, their primary purpose is to deal with exceptional volatility in a particular security.
Rather, the job of catching fat-finger trades should fall first on traders and then marketplaces, the IIROC paper suggests. Certain trader responsibilities already are enshrined in the trading rules, but these would be augmented by a proposed rule governing electronic trading, which is still under consideration by the Canadian Securities Administrators (CSA).
That proposal requires that investment dealers have appropriate policies, procedures and controls in place to manage the risks associated with electronic trading. This rule also would impose an obligation on marketplaces to adopt volatility controls. The proposed rule doesn’t mandate specific requirements; rather, it demands that markets adhere to price and volume thresholds established by the market regulators, which is what IIROC is working on now.
The IIROC paper indicates that this initial paper is the first step in a process that may lead to a formal proposal to establish those thresholds. Comments are due by Aug. 8; any proposal to set such limits also will be issued for public comment.
At the same time, marketwide circuit breakers are also facing changes. Late last year, IIROC initiated a consultation on possible revisions to the way marketwide circuit breakers work in Canada, following a series of proposed changes in the U.S.
Canadian circuit breakers are now geared in the same way as those in the U.S. market, but U.S. regulators are proposing a series of changes to the way U.S. circuit breakers work, seeking to: reduce the amount markets must drop by before a circuit breaker is triggered; cut the duration of the resulting trading halts; simplify the relevant trigger time periods; and change the index used to measure a market decline.
In the wake of those proposals, IIROC has initiated consultations on whether the Canadian system should undertake similar changes, proposing three options: revising the marketwide circuit breakers in line with the changes that are being adopted in the U.S.; introducing a system that’s specific to the Canadian market; or adopting a hybrid approach.
The comment period for that proposal ended in February – and although there was no consensus, there is general agreement that Canadian circuit breakers have to remain aligned with the U.S. because of the similarities in the markets and the significance of interlisted stocks. So, while it remains to be seen if U.S. regulators will follow through on their proposals, Canada is likely to follow if they do.
In the meantime, markets also are contending with looming new rules governing “dark” liquidity (trading that takes place without pre-trade transparency), which are due to take effect in mid-October.
The issues surrounding trading in the dark are somewhat less dramatic than those brought on by the flash crash. Regulators are worried that too much dark trading could impair price discovery and harm investors, but they recognize that some amount of dark trading probably adds liquidity; their concerns aren’t quite as clear-cut as their desire to prevent extreme volatility. Regulators have been wrestling with the question of appropriate rules for dark trading for several years now.
The CSA and IIROC announced their approach in mid-April, including: allowing IIROC to set a minimum size for dark orders, although that hasn’t been done yet; visible orders must be executed before dark orders on the same market; and smaller, transparent orders must receive minimum price improvement when trading with a dark order.
The new rules will be “very significant” to existing dark-trading venues in Canada, says a research note from Toronto-based TD Securities Inc. Furthermore, these markets, along with those that do a lot of dark trading, will likely be unhappy with the new regime.
Ultimately, the TD Securities report says, the new rules are positive for Canada: “The Street will adapt, and our markets will be healthier as a result.”IE
© 2012 Investment Executive. All rights reserved.