Financial exchanges in the US and the UK were for years and years actually quite different sorts of animal; in the US, the profit motive has driven them for a long time, whereas in the UK, the model was one of mutuality, member ownership and ‘not-for-profit’ operation. That difference has eroded in recent years, as, for example, the London stock Exchange and then - later - the LME changed course in a changing world and set out on the road to becoming commercial entities in their own right rather than simply the marketplace for their members to transact business.
In truth, most of the innovation in the way these businesses are run has come from the US - not surprising, really, since they have had years of practice in the commercial world while over here committees of members jealously guarded the status quo. That’s why it’s both interesting and educative to look at the kind of policies and practices utilised in the US.
In recent years, of course, a lot of the changes and developments in the way exchanges have operated have been as a direct result of the growth of computer power and the concomitant increase in speed in the transmission of information. Indeed, a whole new segment of the trading industry - high frequency trading - has emerged predicated on traders’ computer algorithms’ ability to act and react faster than their competitors through the use of algorithmic trading programmes, high-speed data transmission and co-located computers. The volume generated by this type of trading has come to be a significant part of the business for exchanges, and, as commercial operations, those exchanges are obviously keen to protect their income flow.
Changing Rules...Creating Clarity?
So it’s quite striking that, in the wake of rule changes made a few months ago by the CME Group, a similar set of regulations is now being introduced by ICE to police and control such automated trading. These changes concern ‘disruptive trading practices’. The Dodd-Frank reforms of 2010 made disruptive trading illegal, and since then the CFTC has issued various guidelines about ‘spoofing’. Regular readers of this site may recall that I referred a short while ago to the case of Michael Coscia, who is being prosecuted on charges relating to theses kinds of activities. So it’s probably fair to say that the US authorities and the exchanges themselves are taking the issue seriously. The problem comes when we try to define ‘disruptive trading practices’; one man’s meat is another man’s poison. The regulators - and the exchanges, as self-regulatory entities, are in the front line - have a tightrope to walk when they try to separate what may be ‘disruptive’ from what may simply be a legitimate order to trade. ICE have tried quite hard, publishing a list of FAQs to accompany the new rule changes, but to be honest, I don’t think that they have achieved their objective of creating clarity. The kernel of the problem, surely, is that in order to separate the wheat from the chaff, it is necessary to understand the intent of the trader entering the order. I fear that court arguments about ‘intent’ will quite easily become reminiscent of medieval theologians debating how many angels can fit on the head of a pin. For the exchanges, it’s a tough call. They can see the potential disruption caused by unfettered high-frequency algo trading - if they didn’t see the problems, why would they go to such lengths to try and isolate it? - yet they need the volume and the fees that it creates. It’s not a comfortable position to be in, I wouldn’t have thought, trying to control a growing monster without really understanding how to do it. And that’s not intended as a criticism, entirely, of the exchanges: they are caught between two stools.
Learn from Experience
I take my hat off to ICE for attempting to produce a regulation and a commentary to go with that regulation that tries to clarify what may or may not constitute ‘disruptive trading’; unfortunately, I don’t think they have achieved their aim and I don’t think they have solved anything. Given my first premise - that the US leads the UK by some way in this area - were I running an exchange, I don’t think now would be the time I would choose to offer financial incentives to attract HFT onto my market - that would look to me like asking for problems. And yet that is just what it seems one exchange we all know well has been considering. Volume is good, for an exchange; but liquidity is even better and the two are not synonymous. The US experience with HFT has not been particularly encouraging; surely there are better routes to follow, rather than walking, eyes wide open, into what has elsewhere proven to be a problematic environment. Or does the need for income trump everything?
I have to thank the one and only Ted Arnold for bringing ICE’s new rules to my attention.