A step into the unknown(2)
Although the last few weeks will be remembered for extreme levels of market volatility, this is not the only current cause of concern for market participants.
August is supposed to be a quiet month in the financial markets. What went wrong?
During the first two weeks of last month, traders faced chaotic market volatility. This was caused by a massive dumping of stock as investors lost confidence in the ability of the eurozone and the US to meet debt obligations. As a result, trading volumes in Europe for example were almost double the same month last year.
Traders that hadn't escaped to the beach were forced to adapt their execution strategies – some paring back levels of self-directed trading – to deal with tumultuous markets.
In the aftermath, many asked whether high-frequency traders had made a bad situation worse.
Academic studies have presented evidence that high-frequency trading (HFT) could have actually dampened volatility, but this didn't stop former UK financial services secretary Lord Paul Myners describing HFT as “fraught with hazard”.
Regardless, investors remain edgy, unsure what will spark the next bout of market turmoil.
Is handling volatile markets the ”only' concern?
Not at all. Since the financial crisis, regulators' subsequent drive toward greater transparency and lower levels of systemic risk has generated a whole slew of regulations to prepare for.
One of the most significant of these for equity traders will be MiFID II, the initial draft of which the European Commission is expected to finally present next month.
Based on an EC consultation in December 2010, MiFID II could subject HFT firms to liquidity provision requirements, impose a minimum size threshold on dark trades and drastically reduce the trade reporting delay regime. These three alone would have a large bearing on execution performance, but the time elapsed since the original proposals adds to uncertainty over which amends to MiFID will be adopted.
There is also the Dodd-Frank Act in the US and the European market infrastructure regulation (EMIR), both of which will result in a major restructuring of over-the-counter (OTC) derivatives trading.
Much of Dodd-Frank's derivatives rules will come into force at the end of this year, having been delayed from an initial implementation date of July this year, while EMIR is currently in the hands of the European Parliament and the Council of the European Union with a number of core points yet to be resolved.
Research consultancy TABB Group estimates that the back-office technology spend required to comply with the OTC derivatives rules could reach US$3.5 billion. But the lack of clarity in key areas makes it difficult for the industry to plan for the future.
This only scratches the surface of new regulation, with other rules relating to capital adequacy, market abuse and collective investment schemes also in the process of negotiations among various regulators. For many, Basel is the big one.
What could the drive by regulators to improve transparency mean specifically for the buy-side?
Ever since the first version of MiFID came into force in 2007, buy-side traders – particularly those in the UK – have complained about a lack of quality post-trade execution data.
At the moment, there is no standardised consolidated post-trade data source, which limits the ability for traders to assess execution quality and make accurate investment decisions. OTC reporting for equities is adds another layer of doubt as there is no distinction between bilateral trades, those done in broker crossing networks or trades that do not result in a beneficial change of ownership.
These issues will be dealt with in MiFID II and have also been addressed by numerous industry working groups that are actively working to find solutions. Nothing is certain yet, but the collaborative industry approach in this area may offer some solace.
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