As the US and the EU allow alternative trading venues to compete with exchanges, noted Martin Wheatley, CEO of the Hong Kong Securities and Futures Commission, the resulting market fragmentation must be weighed against benefits to investors such as more competitive pricing and innovative services. In remarks at the TradeTech Hong Kong conference, Mr. Wheatley said that the SFC welcomes competition as long as investors’ interest is not compromised and the market continues to be fair, efficient and has its integrity intact. The Commission’s concern is whether diverse platforms are accessible in a non-discriminative manner and whether multiple data sources can be reintegrated at the user level at a reasonable cost.
In the Securities Reform Act of 1975, Congress amended the Exchange Act essentially removing the monopoly status of exchanges in the US. This allowed competition amongst different trading venues and decentralized equity trading from US exchanges. This resulted in a significant migration of trading volume away from the exchanges.
A similar change in Europe removing the monopoly status of exchanges came into effect in late 2007. There is a lot of published data which show that trading volume has migrated from exchanges to alternative trading venues.
The HKEx remains the sole exchange operator in Hong Kong, said the SFC CEO, and the monopoly status that the HKEx enjoys is entrenched in Section 19 of the Securities and Futures Ordinance and this will remain the case until Section 19 is amended. The issue of whether Hong Kong should follow the US and EU is a policy question which falls within the purview of the Government.
But Mr. Wheatley noted that regulators in the US and Europe continue to grapple with issues associated with market fragmentation, which will exist as long as a multiple-market operator structure continues to exist. These issues loom large and involve transparency and market depth.
According to Mr. Wheatley, as orders are spread among a number of different trading venues, the market depth of each venue is reduced and execution of a large order in any one of the trading venues is more likely to produce an adverse price movement. Also, the reduction of order book depth may widen the bid-ask spread of the market.
Moreover, when trading activities are conducted on different platforms, pre- and post-trade information are not consolidated and displayed from one source, reducing overall market transparency. A consolidated price tape may help, he conceded, but not all investors can or want to pay for price feeds from individual platforms directly. Sophisticated or institutional investors who can afford to pay for the price feeds will receive the information earlier than others who rely on the consolidated price tape.
In the view of the SFC official, strict price time priority of order matching cannot be guaranteed in a multiple-market structure. Orders with an inferior price may get filled in one trading venue while orders with a better price may still be waiting for execution on another venue. This may result in a less reliable and less stable price discovery process
Since market fragmentation can also bring new forms of trading abuses, warned the official, regulators must be vigilant and put in place appropriate market surveillance practices and systems. If the exchange is the front line regulator undertaking the market surveillance responsibility, he emphasized, a conflict of interest issue may arise when there are multiple trading venues competing with it. Thus, it may no longer be appropriate for the exchange to perform surveillance functions for the market as a whole. Regulators are expected to take up the function and ensure that market surveillance can be performed effectively under the fragmented market structure.
Another issue is fair access to clearing and settlement facilities. Exchanges in Asia usually own the only clearing and settlement facilities in the market. Unlike trading platforms, the set-up costs for clearing and settlement facilities are high and therefore there has not been sufficient competition in the clearing and settlement space to drive the costs down. It is essential to have fair access to clearing and settlement facilities to enable a level playing field between exchanges and alternative trading venues.
In November 2010, the SEC rolled out rules imposing pre-trade risk management controls for brokers offering direct market access that require pre-trade filtering by the brokers’ system. Mr. Wheatley said that these rules effectively ban naked or unfiltered access. Hong Kong does not have specific regulations on the use of direct market access, said the SFC official, but the Commission is closely monitoring it. Some firms have about 20 percent of their trading in the Hong Kong stock market associated with direct market access.
The Commission will have to weigh the increased cost of pre-trade filters and an overall reduction in liquidity and trading volume with the benefit of having pre-trade filters, including reducing risks to brokers and the market, enhancing market integrity and investor protection.
In August 2010, IOSCO published principles for Direct Electronic Access to Markets designed to guide intermediaries, market operators and regulators in several areas, namely, pre-conditions for direct market access, information flow and adequate systems and controls. The SFC is considering whether additional requirements or guidelines should be introduced at both the exchange and broker levels to ensure that the use of direct market access will not result in undesirable consequences and increased risks to the market.
Compared to the US and EU, he continued, dark pools are in their infancy in Asia, One of the key reasons is that the exchanges in Asia have monopoly status (actual or de facto) and alternative trading venues cannot compete with the exchanges on a level playing field. As a result, most of the issues associated with dark pools which regulators in the US and Europe are grappling with such as the lack of transparency, impaired price discovery and the lack of fairness are not posing any real concerns to the SFC at this juncture. However, the CEO stressed the importance of keeping a close eye on the development of alternative trading venues in Hong Kong and, when the situation warrants, the Commission would consider appropriate regulatory responses.
High frequency trading has not gained much traction in Hong Kong, noted the official, at least not in the equities market. This is largely due to the frictional cost of trading equities in Hong Kong. The stamp duty of 0.1% of the transacted value payable by the buyer and the seller respectively can easily exceed the wafer-thin profit per HFT trade. Stamp duty is not required to be paid on trades in the US and many of the major markets. Although trades attract stamp duty in the UK, only the buyer is required to pay.
Mr. Wheatley views HFT as more a technology rather than a strategy. He believes that any HFT regulations should be technology-neutral, meaning that whether a technology is a Generation X technology or a Generation Y technology it should be subject to the same rules regarding trading obligations and trading abuses. It is not sensible to customize regulations to cater for a particular technology.
Nonetheless, he acknowledgers that the very nature of HFT has the potential to bring risks and fragility to the market,especially during a market dislocation. There are various measures to address this, such as circuit breakers or the imposition of penalty charges where there is an overly disproportionate order-to-execution ratio.