With 2010 on the shelf, we offer our market structure thoughts for the coming year. As in years past, a reconciliation of last year’s list with actual outcomes follows.
Limit up/down replaces circuit breakers. With industry support, the Securities and Exchange Commission works with exchanges to replace the current single-stock circuit breakers with a "limit up/down" structure that prevents trading beyond a certain threshold. Unlike futures markets, however, the equity flavor of limit up/down kicks to an auction if prices don’t bounce off the limit after a brief pause. The current price threshold of 10 percent is lowered to 5 percent. In the interest of uniformity, NYSE relinquishes its "liquidity replenishment points," and Nasdaq mothballs plans for a "volatility guard." On the marketwide side, the current Dow-based halts at 10, 20 and 30 percent are replaced with S&P 500-based triggers at lower levels. The upshot: Between limit up/down and the new minimalist market-maker standards, markets close 2011 with insurance against the most aberrant aspects of last May 6’s "flash crash."
Exchanges pursue internalization 2.0. With offboard trading stubbornly above the 30 percent share volume threshold, exchanges try a number of experiments designed to dislodge order flow–particularly retail–traditionally handled by wholesale market makers. These "internalization 2.0" efforts take the form of aggressive rebates for marketable orders, price-improvement schemes involving sub-pennies and rate cards that attempt to proxy for "toxicity." While the endeavors aren’t wildly successful, flow providers are open to experimentation after poor performance by internalizers during the flash crash, and regulators offer quiet encouragement. We end 2011 with a modest downtick in trade-reporting facility (off-exchange) share.
Speed bumps for HFT. On the back of another year of controversy, the high-frequency trading community hits speed bumps. The increasingly crowded nature of many HFT strategies, coupled with a dearth of natural order flow and rising operational costs, culls the herd a bit. The desire to better regulate HFT is operationalized by FINRA and the SEC, increasing only perceived risks for most HFT actors, but presenting a real threat for the small minority of bad HFT apples. Industry calls for taxes on high levels of canceled orders gain traction and enjoy the support of regulators. A number of exchanges have them in place by year-end.
Market access gets algo module. In the wake of May 6, the Commodity Futures Trading Commission put forth the concept of a "disruptive algorithm," suggesting an appropriate area for policy-making. This line of inquiry reaches a boil in 2011. Happily, regulators pursue a "policies and procedures" means to address algo-related risks, as opposed to prohibitions, prescriptions, registrations or other "high-touch" means. On the securities side, this approach amounts to an extension of the SEC’s new market access rules to address algorithmic instructions. The new "algo module" is implemented along with the full raft of rules in Q4.
Regulatory light hits dark pools abroad. While the U.S. awaits action on the SEC’s three proposed changes to rules governing dark pools, regulators around the world go activist on this front. In Canada, a proposed minimum order size for dark orders is discarded, but minimum price-improvement increments are formalized. Australia, by contrast, adopts an A$20,000 minimum size for dark orders. In Europe, MiFID II opens up a yearlong marathon of industry navel-gazing, with considerable focus on internalization. While the outcome remains unclear at year-end, the outline of a "grand bargain" emerges, in which dealers offer increased transparency via a true consolidated tape in exchange for the continued ability to internalize–subject to more stringent standards.
CFTC brings Dodd-Frank to market. Working against a July 15 deadline, the Gary Gensler-led CFTC continues its rule-making torrent, as it moves its Dodd-Frank proposals of late 2010 into final form. Despite changes in congressional oversight and continued industry pushback, the CFTC is largely successful, in terms of both timing and scope. We end 2011 with considerable clarity about what the "new model" over-the-counter derivatives world will look like. With ECN-like "swap execution facilities," TRF-like "swap data repositories," concentration limits for trading venues and clearinghouses, and SRO-monitored rules for margin, conduct, conflict management and other intermediary practices, the answer is pretty clear: equities.
Futures exchange melee. As new CFTC rules open a path to prominence for exchanges in OTC derivatives trading and clearing, competition amongst the field ticks higher. NYSE rolls out NYPC, which offers cross-margining between cash bonds and futures, and its arrangement with MSCI turns exclusive, both of which challenge CME. ICE broadens its financial line with a new product launch. One (or both) of ELX and Nasdaq’s IDCG will be sold, possibly to a foreign buyer looking for exposure to a perceived opportunity.
SEC approves slimmed-down CAT. The SEC approves its Consolidated Audit Trail by midyear. After much debate over scope and cost, the commission punts on the contentious real-time elements of CAT, reducing costs substantially. A number of financial technology firms–including a few exchanges–bid for the project, but ultimately independence and continuity argue for FINRA’s selection. Work begins, but full implementation waits for 2012 (if not beyond). The question of how to use the data–sound surveillance techniques and the like–remains an important open item.
2010 predictions scorecard. After a shameful 2009, mean reversion smiled upon us. We got it right on four, wrong on one and pushed on two.
The SEC squarely raised the question of internalization and a "trade-at" rule in its January concept release, and, though "flash orders" remain legal (for now), Direct Edge has filed to allow midpoint pricing in its CPI (né ELP) auction. Regulators turned attention to the high-frequency world, particularly after the train wreck of May 6, and "naked access" will leave our lexicon in July via new SEC Rule 15c3-5. FINRA longs were rewarded by its assumption of NYSE’s regulatory functions and its pole position to construct the SEC’s proposed Consolidated Audit Trail. Political risk became more tangible and specific with Dodd-Frank’s passage in July, with the CFTC leading the subsequent charge to beat statutory plowshares into regulatory swords.
On the debit side of the ledger, we went blind on dark pools, as the SEC left undisturbed its October 2009 proposal to limit use of indications of interest and update Reg ATS. We pushed on the exchange landscape: Equities exchanges delivered the predicted doldrums, and volumes were weaker, but our options calls missed the mark widely. (CBOE’s C2 launched in October, and BATS ends the year with 1 percent-ish, not 5 percent, market share.) Derivatives fungibility is a second push.
Although it appears that the CFTC’s "open access" standards will apply to OTC derivatives that migrate to central counterparty clearinghouses, the industry still awaits an attempt by ELX to execute an EFF against CME’s clearinghouse, and NYSE’s joint venture with the Depository Trust & Clearing Corp. ends 2010 as yet unapproved by the CFTC.
Jamie Selway is a managing director at Investment Technology Group. The opinions and predictions expressed in this column are his own and do not necessarily represent those of ITG.
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