Regulator warns of electronic trading risks

A regulatorÆs job is to find the right balance between the risks and rewards of electronic trading, says Hong Kong Securities & Futures Commission CEO Martin Wheatley.
Advances in technology have altered the landscape of financial markets worldwide and regulators should be alert to the risks that come with the latest developments, particularly in electronic trading, says Martin Wheatley, CEO of Hong KongÆs Securities & Futures Commission (SFC).

ôIt is now clear that the days of exchange floor trading are coming to an end,ö says Wheatley. He made the remarks at the sixth Asia-Pacific Trading Summit in Hong Kong. ôTo say it is a challenge for regulators to keep up is an understatement.ö

A regulatorÆs job is to find the balance between the risks and rewards of electronic trading, Wheatley says. The emergence of alternative trading venues and the increasing use of highly advanced trading tools are among the more challenging regulatory issues because they have had the greatest impact on the structure of financial markets.

In recent years, there has been a frenzy of M&A activity among exchanges to create larger trading networks, and not even the oldest and biggest of them has been immune to this trend, Wheatley notes. The NYSE/Euronext, Nasdaq/OMX, and CME/CBOT mergers are among the more prominent examples. Simultaneously, exchanges have also started to branch out into new markets like derivatives and commodities to attract new liquidity pools and to boost their revenues.

On the part of the users, there has also been increasing demand from buy-side firms to move their portfolios in blocks, and to do so with minimum market impact and information leakage.

ôConventional exchanges are unable to meet these firmsÆ needs as they commonly trade in smaller values, charge high trading tariffs, and sometimes even display broker identifiers,ö he notes. ôConsequently, alternative trading venues have emerged to provide buy-side firms with anonymous block trading at lower transaction costs.ö

These alternative trading venues pose some specific regulatory challenges, and Wheatley asks the most pertinent questions: How to ensure a level playing field between conventional exchanges and new trading venues? What level of pre- and post-trade transparency should be provided? What should be done to ensure alternative trading venues do not lead to liquidity fragmentation?

All things being equal, regulation should aim to facilitate fair competition among different market players and business models, and not give an unfair competitive edge to any one over another, Wheatley says. In the US and Europe, specific rules and regulations have been put in place to address these concerns.

In Hong Kong, the legislation is not quite so specific, Wheatley notes. The Securities & Futures Ordinance (SFO) establishes a fairly flexible framework for the regulation of automated trading systems.

With regard to pre- and post-trade transparency and liquidity fragmentation, alternative trading venues raise difficult questions about the extent to which the brokersÆ clients are achieving best execution. The US and Europe have put in place regulation requiring best execution, particularly in the context of internalisation and preferencing of trades.

Hong Kong does not have this problem for now because there are no alternative trading venues for investors. ôThe situation is likely to stay unchanged in the foreseeable future given the Stock Exchange of Hong KongÆs monopoly which is enshrined in the SFO,ö Wheatley says, adding that there is nevertheless a need keep an eye on these developments internationally.

The advanced trading tools that are finding their way into Asia are also of particular concern to Wheatley.

ôSpeed and timing are of the essence in electronic trading today,ö he says. ôEven a second is now intolerably long for sophisticated traders who measure the time it takes to transmit an order in milliseconds.ö

Indeed, Singapore Exchange (SGX) and Singapore Telecommunications signed a deal in late-May to provide traders with ultra-low latency access to SGX securities and derivatives markets. That makes SGX the first exchange in Asia to offer sub-millisecond access to its trading engines. The more common trading tools today are algorithmic trading or direct market access (DMA).

The International Organization of Securities Commissions (Iosco) is looking into issues relating to the use of some of these advanced trading tools. It is conducting a survey of its member jurisdictions on the regulation of DMA and has also begun a study on its risk management at the intermediariesÆ level.

As regulators, ôwe welcome the changes that advances in technology bring,ö Wheatley says. ôHowever, we must at the same time be alert to the risks that new technologies and developments can pose for the market as a whole, and endeavour to address these pragmatically.ö

For an in-depth look at trading execution, see the June 2008 edition of AsianInvestor magazine.
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