Distractions, delays and Dodd-Frank: Will 2011 deliver where 2010 failed?

The recovery from the financial crisis started in earnest in 2010 as governments and regulators began metaphorically nailing down bits of the market.
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The recovery from the financial crisis started in earnest in 2010 as governments and regulators began metaphorically nailing down bits of the market. Although their intention has been to secure the global financial infrastructure against further shocks, the biggest worry for 2011 is that new rules will inhibit innovation, competition and growth.

For many, the crisis itself was obscured this year by a new calamity – albeit one that lasted just 20 minutes. The ”flash crash' of 6 May saw the value of the Dow Jones Industrial Average fall 1,000 points before recovering. It generated headlines worldwide and led US regulators to conduct a five-month investigation into its cause. They concluded that a single, large volume, sell trade of futures contracts was the catalyst for a rapid withdrawal of liquidity by nervous market makers that precipitated a fall in prices across the board.

What 6 May clearly showed was that market uncertainty is a bandwagon says Bradley Duke, managing director, Europe at broker Knight Capital. “We all witnessed the massive frenzy that followed, where it was all too common to see the blurring of hype and reality. The event became a lightning rod for a diverse mix of agendas,” he says.

Steve Grob, director of strategy at trading systems supplier Fidessa, agrees. “A market dislocated itself for 20 minutes and then sorted itself out. In some ways that shows its robustness,” he says. “But the wider reaction – such as the calls for action against high-frequency trading – bordered on hysteria.”

One major effect of the crash was the decision by US regulators to install market-wide circuit breakers that halt trading in a stock for five minutes if its price moves more than 10% in a five-minute period. Matt Samelson, principal at US-based consultancy firm Woodbine Associates, approves of the move, but has a warning for rule makers: “You put a rule in place to close one issue, and it creates others. Rule-making is a continuous process. [The crash] has drawn attention to algorithms, how markets are interrelated, how regulators put in place mitigating controls, etc. But you never know when the next ”perfect storm' of events is going to happen.”

In July, the US saw the Dodd-Frank Act come into law, which – as part of a wide-ranging reform programme – took an axe to large US banks' proprietary trading operations and investments in hedge funds and private equity to limit their risk taking. It also sets out to create a more secure derivatives market through greater use of central clearing and increased on-exchange trading. Although it will be some time before regulators effect every rule within the act, the principles that the US government have established are likely to be the base for regulation across the globe. “I think that act itself could be just the beginning of the next wave of regulatory and market structure changes which I am sure will not just be related to the US, but could see many of the principles permeate around the world in coming years,” says Stuart Adams, regional director, EMEA for securities messaging standards body FIX Protocol Limited.

On the other side of the Atlantic, the European Commission is currently consulting on changes to MiFID and promises regulatory and structural reform for European securities markets in the shape of MiFID II, scheduled to be proposed in Q2 2011. The much-anticipated consultation lays out major changes to the categorisation of dark pools and suggests options for a consolidated tape of post-trade data. In tandem with a planned European market infrastructure regulation, MiFID II will also reform OTC derivatives trading in Europe along similar lines to US proposals.

“With such a broad scope, and such a short consultation period, it's hard to be clear on how the MiFID review will achieve its goals in a uniform manner. I would prefer a more considered approach, with time and energy devoted to gathering empirical evidence, and separation of the key components into separate projects, rather than a rush to regulate,” cautions Natan Tiefenbrun commercial director, Turquoise at London Stock Exchange Group.

A newly created pan-European regulatory body, the European Securities and Markets Authority, will attempt to manage the implementation of these rules across the continent, but tough market conditions will make it hard for venues and other market participants to adjust smoothly, says Cyril Theret, CEO of UK small to mid-cap trading venue PLUS Markets. “Growth has not materialised, and it will not,” he warns. “A lot of business models are being challenged from a profitability/break even point of view. With Chi-X for sale, the London Stock Exchange trying to diversify – it's one of the main challenges for the industry. The second is the regulatory challenge. MiFID was significant, but what's coming in 2011 is even more significant. Not only do we have MiFID II on the cash equity market, we have a much wider range of instruments.”

This pace of change carries its own dangers, says Grob. “People can develop innovative technology and roll it out faster than regulators can pass laws. What then happens is you then tend to get an overreaction, which leads to unintended consequences. I think this will be an even bigger risk for next year,” he asserts.

With so much pressure on legislators, Guy Sears, director of wholesale at UK buy-side industry body the Investment Management Association, notes that a distracted regulator, risk aversion and regulatory arbitrage are all potential problems in 2011, adding that he hopes “that regulators will stop chasing shadows and start filling in the cracks”.

A frustration across the board in Europe has been the failure of regulators and central counterparties (CCPs) to agree a framework for interoperability between the CCPs, which had been expected in 2010. “We would hope to see full interoperability in the post-trade environment in 2011 because without interoperability, true post-trade competition cannot take place,” says Duke.

Achieving this goal will require the clearers to remain focused says Wayne Eagle, head of markets at CCP LCH.Clearnet, adding, “If they don't, there is the possibility that users may not receive the choice and the power that they deserve. Otherwise we'll end up with structures that don't suit the market.”

Although agreement between CCPs and regulators moved a step closer in December, Diana Chan, CEO of EuroCCP, points out that trading venues, as “gatekeepers” to the trade data feeds needed by CCPs to facilitate interoperability, also have a key role to play in reaching the post-trade end-game. But in this space, as with so many others, regulatory uncertainty is the key concern for 2011.

“The most significant and expected change for the clearing industry is the European market infrastructure regulation, but we won’t know the precise requirements for clearing until it is finalised in mid-2011,” says Chan. “Meanwhile, there are several other initiatives which could impact clearing: the MiFID review; the Basel Committee’s work on banks’ capital requirements on exposures to CCPs; and the joint review of CCPs by the Committee on Payment and Settlement Systems and the technical committee of the International Organisation of Securities Commissions. Although they all share the objective of making the marketplace more robust, it is a lot happening all at the same time.”