Playing the waiting game

Many market participants have adopted a wait-and-see approach to preparing for the major regulatory changes coming in the near future and many , but the risks to such a strategy may outweigh the benefits.

The regulatory tsunami has been a long time coming, but when exactly will it hit and market participants aptly prepared? 

Firms have logically adopted a wait-and-see approach to compliance. However, as such a swathe of rules will come into force in a short space of time, some level of preparedness would seem prudent.

The list of new rules set to come into force over the foreseeable future in Europe and North America runs deep, across asset classes, will bring into existence new venues and extends to off-exchange trading.

Although regulatory risk is front of mind for buy- and sell-side participants, it’s not clear they’ve done enough to ready themselves, as the new rules solidify in coming months.

There are currently new regulations recently in place, some etched out and ready to come into force soon, and others yet to crystallise. In the US, some of these include the Dodd-Frank Act, Commodity Futures Trading Commission (CFTC) guidelines on algo testing and in Europe, MiFID II and EMIR are all set to come into force, in addition to the global Basel III rules.

But what kind of impact will these new rules have? 

New rules on swaps trading as part of the Dodd-Frank Act from the CFTC will take effect from the end of the year, classifying high-volume users of swaps. The impending rules have already seen a migration of flow from swaps to futures, mainly in the energy sector, with derivatives venues creating tailored futures contracts to mirror the structure of swaps instruments that would incur higher trading fees under the new rules.

This may be a warning sign of things to come, as the rapid pace of change ahead of the rule change will not only affect those users wanting to avoid higher trading fees, but all other participants who will be forced to follow the larger players as they will dictate where liquidity lies.

The adoption of a half-second resting time for orders as part of MiFID II rules could also see a major change to liquidity in European venues as high-frequency trading (HFT) players alter their behaviour. Although due to come into force in 2014 at the earliest, MiFID II could dramatically change the landscape of European equity markets.

These examples are just the tip of a very large iceberg, and the vast amount of rule changes that will occur in a short space of time could well have a flow-on effect to the trading patterns of all market participants.

With new rules likely to alter slightly from their inception, should market participants continue to play the waiting game? 

The stab of urgency market participants feel with every headline charting the incremental impact of these new regulations is related largely to compliance, they will also have an impact on revenues and reputation. There are business reasons why firms must prepare for this new climate, not simply regulatory reasons.

Recent major market crises have caused both intense commercial losses and increased scrutiny of those who break the rules, driven in part by a media witch hunt bent on shaming market participants.

Knight Capital’s algo failure, which wiped US$440 million from the company, and Nasdaq’s error-laiden Facebook IPO have fed a post-global financial crisis appetite for fuelling negative press on financial markets. Both issues were caused by electronic trading glitches and were covered with a granularity that would have been non-existent before 2008.

There will be business implications for non-compliance aside from regulators’ fines, so perhaps firms should not focus too heavily on the practicality underpinning the raft of new regulations, and adapt processes ahead of the new rules’ implementation dates.

So how do I prepare when things aren’t yet finalised? 

Whether an inter-dealer broker looking to set up a swap execution facility under the Dodd-Frank Act, or large sell-side organisation needing to comply with an extension to the Market Abuse Directive to commodities, firms may look now to adaptive tools to incorporate rule changes. 

Playing the waiting game any longer may not be a net benefit to a business, so a flexible approach based on what is expected may the best option to handle the vast regulatory change ahead.

The nature of rule making in both the US and Europe is one of refinement, and rules expected to come into force will be altered as their effect becomes clear, further incentivising a need for an elastic approach to preparedness.