Edwin Schooling-Latter, head of markets infrastructure and policy at the Financial Conduct Authority, said the UK regulator had seen mini-flash crashes in UK stocks and will continue to carefully review electronic trading.
Schooling-Latter said at the FIX EMEA Trading Conference in London on 3 March that the UK regulator looks at a lot of data in order books and could see that algorithms did not always function as intended. “We have observed mini flash crashes in single stocks,” he added.
On 6 May 2010 the Dow Jones index lost almost 9% of its value in 20 minutes in what has been dubbed a “flash crash.” As a result US regulators introduced market-wide circuit breakers that halt trading in specific circumstances. Schooling-Latter said well-designed circuit breakers play an important role in maintaining market resilience.
“The London Stock Exchange invoked circuit breakers 9,700 times in 2014 alone, some of which were linked to news items, but also due to orders input carelessly or incorrectly,” he added.
Three-quarters of the circuit breakers were in illiquid securities listed at the LSE, but 200 were in FTSE 250 stocks and 14 were in FTSE 100 equities. Schooling-Latter continued that MiFID II, the incoming regulations covering financial markets in the European Union from 2018, will require all trading venues in the region to have circuit breakers.
He added that the FCA views the increased electronic trading across asset classes as bringing many advantages such as straight-through-processing and post-trade efficiencies.
“However there is an arms race to be the fastest and a debate is needed over whether the risks outweigh the benefits,” said Schooling Latter. “We believe high-frequency traders are less likely to withdraw in volatile markets, as volatility offers opportunities for profit, but careful study is warranted.”
Schooling-Latter continued that high-frequency trading has become more established in foreign exchange, and some sovereign bond markets, which may affect the functioning of financial markets and the real economy, so electronification has become an increasing concern for policymakers.
“In normal markets HFT firms are an important provider of liquidity,” he added. “In times of stress they may withdraw liquidity when it is most needed and increase the likelihood of price moves.”
This was echoed by the Bank for International Settlements in its latest Quarterly Review yesterday. The BIS said in its report that the rising use of electronic trading) is shaping price formation and the nature of liquidity provision as new market participants, trading venues and protocols have proliferated, particularly in corporate credit markets.
“The success of these new platform initiatives, however, has been limited thus far,” added the BIS. “Overall, these developments have led to a more diverse market structure.”
The BIS surveyed more than 30 fixed income electronic trading platforms and found that volumes grew most in the dealer-to-customer segment, where end users can put multiple dealers in competition for a trade, and for venues relying on a request-for-quote.
“All-to-all platforms, however, contributed little to the rise in aggregate volumes,” said the report. “This was also reflected in the sluggish growth of central limit order book-based trading over the past years
The BIS added that it was difficult to judge whether central limit order books or quote-driven markets work best in stressed market conditions.
“One concern is that abrupt but short-lived price swings (“flash crashes”) may become more frequent in highly automated fixed income markets,” said the BIS. The report cited the flash rally in the US Treasury market on 15 October 2014 where an algorithm may have contributed to extreme price swings.
“It is, however, important to note that the basic underlying economic mechanism of how illiquidity risks unfold appears to have remained largely unchanged,” said the BIS. “Indeed, irrespective of the underlying market microstructure, market conditions remain susceptible to a sudden evaporation of liquidity.”
The report also noted that traditional gauges of liquidity conditions may be less suitable in the new market environment and additional metrics may be needed to monitor liquidity more accurately. The BIS gave the example of implementation shortfall, which captures the total costs of establishing a position in a security of a given size.
“With trading activity increasingly gravitating towards platforms, ensuring their robustness as well as their capacity to deal with market stress becomes a key financial stability issue,” said the BIS. “With dealers closing down traditional trading desks (“hanging up their phones”), while their e-trading desk algorithms connect to an expanding set of multilateral platforms, the fallback option of returning to voice trading may no longer be viable.”
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