Response to CESR Call for Evidence on Micro-structural issues of the European equity markets

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1 EBF Ref.: D0618E-2010 Brussels, 30 April 2010 Set up in 1960, the European Banking Federation is the voice of the European banking sector (European Union & European Free Trade Association countries). The EBF represents the interests of some 5000 European banks: large and small, wholesale and retail, local and cross-border financial institutions. The EBF is committed to supporting EU policies to promote the single market in financial services in general and in banking activities in particular. It advocates free and fair competition in the EU and world markets and supports the banks' efforts to increase their efficiency and competitiveness. Response to CESR Call for Evidence on Micro-structural issues of the European equity markets Key Points The European Banking Federation welcomes CESR s thorough research around the issues addressed in the current consultation paper. To date, banks have not identified significant difficulties, but the Federation remains open to CESR s findings. In considering possible regulatory intervention, care must however be taken not to undermine technological progress, but to rather look at trading behaviour. As a second principle, regulation must seek to ensure equality of opportunities, as opposed to equality of outcome. Clearly, market abusive behaviour must not be tolerated. The EBF supports the strengthening of the tools available to supervisory authorities, where this is considered necessary or helpful. If additional rules are considered necessary, it should be considered to introduce them through the trading platforms own rules; or alternatively, through Level 2 or Level 3 of the Lamfalussy process. Contact Person: Uta Wassmuth, u.wassmuth@ebf-fbe.eu Related documents: CESR consultation document: European Banking Federation (a.i.s.b.l.) Page 1 10 Rue Montoyer B-1000 Brussels T: 32 (0)

2 I. High frequency trading (HFT) Upfront, the EBF would underline that regulation should not seek to undermine technological progress, and possibly would not be effective if it did. Rather, regulation should be designed to ensure that markets continue to work efficiently under changing market circumstances. With this in mind, the EBF fully supports CESR s work to investigate whether appropriate use is made of new technology, and alternatively to consider possible regulatory intervention. At this stage and without pre-empting any results from CESR s further factual research, banks consider that HF traders merely make use of the superior resources they have legitimately acquired, similar to other investors trading on the basis of substantial investments in market research. This is as opposed to flash orders: the brief displaying of unfulfilled orders to certain trading venue members is clearly a form of market abuse and must continuously be prohibited. 1. Please describe trading strategies used by high frequency traders and provide examples of how they are implemented. Broadly, HFT is a strategy to benefit to the largest possible extent from reduced, sometimes infinitesimal, price spreads or from market anomalies perceived or detected by the trader. Profits are made by executing orders within extremely small periods of time, in the order of nanoseconds. This very low margin activity necessitates high volumes to be profitable, i.e. it is conducted by specialised traders or firms, but is not of interest to retail or corporate market participants. HF orders are therefore characterised by their small size, as well as by the large number or orders. The small order sizes are also used to assess whether there are any buyers or sellers at a certain price level: the risk with such small orders is very small as the price for a negative test result is low. Per se, the practice should not be perceived as problematic. It is a traditional tool for arbitrage strategies, which has existed as long as the stock markets themselves. The new element consists in the use of increasingly powerful IT infrastructure and software, which is a natural adaptation to the new technological possibilities. There is a range of different HF trading strategies. One frequently used strategy is to exploit beneficial fee structures, such as maker-taker structures; meaning that there is no genuine trading interest: i.e., trades are intended to collect fees offered by the trading platforms, and do not represent an actual interest to acquire and hold a certain stock. Other HFT strategies are: - Correlation strategy, which is based on the relationship of two related products, such as a future on the Euro Stoxx and a future on the S&P 500. Assumptions about the way of correlation between the two instruments are derived from historical analysis and are used for the definition of trading orders for both types of instruments, in combination with the analysis of order books and the prices for both instruments. European Banking Federation - EBF 2010 Page 2

3 - Trends trading: orders are automatically formulated on the basis of a fully computerised analysis and reaction to market trends, for example with respect to market depth and the current price momentum of certain instruments. Some market participants are concerned that the large number of small orders and trades might be a challenge for the trading platforms. It can also make the execution of larger orders more difficult and lead to higher settlement costs. 2. Please provide evidence on the amount of European trading executed by HF traders (including the source(s) of that information). CESR is particularly interested in statistical material on: a) market share of HFT in orders/trades in Q1/2010 (and, if possible compared to 2008 and 2009), b) average trade size in Q1/2010 (and, if possible compared to 2008 and 2009), c) market participants, d) financial instruments traded (including cash vs. derivatives). If possible, please distinguish between HFT on transparent organised trading platforms and on dark pools of liquidity. Estimates about the share of HFT of overall trading in the market vary widely. Some EBF members believe that the share of HFT of the overall trading volume could be as high as 50-80%. The EBF is not however in the possession of any statistics and is looking forward to CESR s findings. 3. What are the key drivers of HFT, and (if any) limitations to the growth of HFT? HFT is driven by technology and in particular, increasingly fast computer hardware and internet connections. In combination with co-location of market participants servers close to the trading platforms servers and through the use of trading algorithms, some market participants can gain a time advantage over other market participants. Limitations to growth include the costs of participation and to some extent, other market participants behaviour. For example, other market participants adjust their own trading strategies to avoid that these be anticipated by HF trading algorithms. Nevertheless, technological developments should not be seen as a potential danger but should rather be welcomed as an essential factor for progress. Seeking to limit or thwart the use of technological progress for financial innovation through regulation, as is sometimes suggested, would be a dangerous move and likely not be successful. 4. In your view, what is the impact of high frequency trading on the market, particularly in relation to: - market structure (e.g. tick sizes); - liquidity, turnover, bid-offer spreads, market depth; - volatility and price formation; - efficiency and orderliness of the market? Please provide evidence supporting your views on the impact of HFT on the market. European Banking Federation - EBF 2010 Page 3

4 There are controversial discussions as to whether the benefits of the liquidity generated by High Frequency Traders outweighs the disadvantages perceived by some market participants. Indeed, as regards the different strategies used by HF Traders (pure arbitrage in mid-spread vs. directional and aggressive orders), some participants consider this liquidity as positive, while others believe that it tends to disturb the proper functioning of the market. 5. What are the key benefits from HFT? Do these benefits exist for all HFT trading strategies? Positive results on the markets are manifold: - Any additional liquidity on the markets leads to lower spreads and volatility, in parallel to increasing trading volumes; meaning a net gain for the markets. - Arbitrage strategies contribute to market prices that are as close as possible to fair value. - HFT strategies have contributed to market transparency, by partly replacing the traditional market maker model which is based on non pre-trade transparent OTC transactions. - Reduction of traders market risk: the fact that orders are executed in smaller tranches than without the use of HFT strategies might lead to the atomisation of liquidity in the order books, but also means lower risk attached to each individual order. - Ultimately, more liquid shares attract a greater number of investors, which in turn facilitates the financing of businesses. 6. Do you consider that HFT poses a risk to markets (e.g. from an operational or systemic perspective)? In your view, are these risks adequately mitigated? The gains made by HF traders are derived from arbitrage-like strategies. However, this is a micro-economic issue, similar to that where some market participants seek to increase their investment successes through greater investments in market research. Therefore, European banks have so far not perceived HFT as a possible source of systemic risk. Some market participants are concerned that the small order and trading sizes of HFT might have a negative influence on the execution possibilities of larger orders. The EBF remains open to CESR s further research in this and other respects. From an operational perspective, HFT is demanding on trading platforms IT processes, due to the high number and speed of orders input into the systems, and due to the high number of orders that are cancelled. However, the EBF believes that trading platforms can and should address this challenge through their own rules and necessary IT investments. Indeed, this is already happening to an important degree. Therefore, from banks point of view there is no need for regulatory intervention in this respect. Finally, while market abuse must clearly not be tolerated the full automation of HFT systems considerably limits the risk of market abuse, as operations can be detected more easily. European Banking Federation - EBF 2010 Page 4

5 7. Overall, do you consider HFT to be beneficial or detrimental to the markets? Please elaborate. HFT is a natural response of some market participants to new trading opportunities. It allows these market participants to make gains through high initial investments in the necessary infrastructure. It is a natural feature of the capital markets that these gains are achieved through opportunity costs incurred by other market participants. The EBF believes that such gains are in general legitimate and should not be seen as detrimental to the markets. As noted above however, the EBF welcomes research around possible aspects of HFT that could be detrimental to the markets as a whole, by reducing market efficiency. The focus in such research should be on trading behaviour, against the background that regulatory intervention, if necessary, should be targeted at trading behaviour rather than at limiting technological innovation. 8. How do you see HFT developing in Europe? A steady increase in HFT volumes on the European cash equity markets has been observed over the past few years. This was driven by the lower execution fees that resulted from the competition between trading venues. There are some indications that volumes have dropped since the financial crisis, although if true, this seems to concern absolute rather than relative figures. Generally, if market competition increases further, this could be expected to lead to increasing relative volumes of high frequency trading. 9. Do you consider that additional regulation may be desirable in relation to HF trading/ traders? If so, what kind of regulation would be suitable to address which risks? European banks do not at this stage have any evidence that regulatory intervention is required. However, further monitoring by CESR is considered helpful and important. If CESR s research identifies the need for additional regulation, it should be considered whether such rules could be introduced directly through the trading platforms, so as to preserve greater regulatory flexibility. It is a matter of course that HFT must not be used in a market abusive way, and supervisors should continue to observe the markets closely in this respect. II. Sponsored access Upfront, the EBF would note that: - Sponsored access can be seen as a direct consequence of the implementation of MiFID, which allowed market access to participants other than intermediaries. - Sponsored access is dependent upon the use of co-location (although the reverse is not true). European Banking Federation - EBF 2010 Page 5

6 1. What are the benefits of SA arrangements for trading platforms, sponsoring firms, their clients and the wider market? Sponsored access is a service granted by members of trading platforms to their clients, meaning that it benefits the member granting the access and the client. SA arrangements should however not be used to circumvent trading platforms membership requirements. As regards the impact on the wider market, it is the responsibility of the sponsoring member to ensure that the trading platforms rules are respected. The client is in addition subject to the Market Abuse Directive. That said, a distinction should be made between the following three cases where trading platform members grant access to non-members: - Delocalised screens or remote membership, which constitute a form of Direct Market Access; - Sponsored Access, where sponsoring members use certain filters to control their clients activities (which can also be seen as another way of providing Direct Market Access); - Naked sponsored access, where the trading platform grants its client direct access to the trading platform, without the use of filters and ex ante controls. 2. What risks does SA pose for the orderly functioning of organised trading platforms? How could these risks be mitigated? The firm granting sponsored access, the trading platform, and the supervisory authorities all have a role to play in ensuring that applicable rules are duly respected. This is with regard to both, the trading platforms own rules and horizontal regulation, such as the Market Abuse Directive. For the member of the trading platform, it is easier to control his client s activities and to thereby fulfil his own duties in the situation of Direct Market Access, rather than naked Sponsored Access. 3. What risks does SA pose for sponsoring firms? How should these risks be mitigated? Sponsoring firms must be aware of their clients use of the access to the trading platform, so as to ensure due respect of the applicable rules. However, sponsoring firms are not responsible for events carried out in other parts of the markets. Only the trading platforms and the supervisory authorities have the entire picture of information and must consequently ensure to monitor the market as a whole. 4. Is there a need for additional regulatory requirements for sponsored access, for example: a. limitations on who can be a sponsoring firm; b. restrictions on clients that can use sponsored access; c. additional market monitoring requirements; d. pre-trade filters and controls on submitted orders. European Banking Federation - EBF 2010 Page 6

7 With respect to a), a natural limit is already in place as only members of the trading platforms can be sponsoring firms. With respect to b), sponsored firms should be authorised to deal in investments. With respect to c), the EBF does not believe that additional market monitoring requirements should be imposed on sponsoring members. With respect to d), some market participants believe that it should be a prerequisite for SA that sponsoring firms have appropriate pre-trade filters in place to control their clients orders (i.e., banning of naked sponsored access). Other market participants believe that it should be considered to review the requirements for post-trade controls. If additional rules are considered necessary, it might be appropriate to introduce them through the trading platforms own requirements. 5. Are there other market wide implications resulting from the development of SA? III. Co-location 1. What are the benefits of co-location services for organised trading platforms, trading participants and clients/investors? Co-location, in combination with the use of extremely powerful IT infrastructure and the use of trading algorithms, allows some trading participants to run HFT strategies. Its benefits and disadvantages are thus closely interlinked with those of HFT as such see the remarks under Chapter II. Co-location is one tool to reduce latency to a minimum. This goes as far as to co-locate HF traders and their intermediaries computer servers inside the trading systems to achieve the fastest possible transmission of orders. Co-location also provides additional revenue for trading systems, which charge participants for the slots. This, potentially, raises questions about equal access to the markets. Co-location advocates, however, point out that trading systems have enough slots to accommodate all interested intermediaries. It should also be noted that markets have often allowed certain players to be located closely to the market, especially those that make a special contribution to market liquidity. 2. Are there any downsides arising from the provision of co-location services? If yes, please describe them. In the view of the EBF, it must be ensured that there is equality of opportunity, as opposed to equality of outcome. It would be problematic if access to co-location services was provided in a discriminatory manner. 3. What impact do co-location services have on trading platforms, participants, and the wider market? European Banking Federation - EBF 2010 Page 7

8 As highlighted in the responses under Chapter II, co-location is a prerequisite, or at least facilitator, for HFT. Its impact is to be seen in conjunction with HFT. 4. Does the latency benefit for firms using co-location services create any issues for the fairness and efficiency of markets? Co-location must not be confused with the practice of flash orders, which consists of allowing some market participants to view orders a few milliseconds before they are channelled to the market; i.e. these participants are aware of such orders before the wider public. This practice existed for a while in the US but is now being abandoned, as it allows beneficiaries to frontrun, i.e. to transmit their orders before the information becomes public. As noted above, flash orders are prohibited in Europe and should remain so. 5. In your view, do co-location services create an issue with the MiFID obligations on trading platforms to provide for fair access? Fairness, in the view of the EBF, is to be understood as equality of opportunity. All market participants must benefit from the same conditions of access to information or to co-location services, if interested. In addition, co-location should not only be open to the trading platforms members, but also to data providers. As long as equal conditions of access to co-location are provided, banks are not concerned about co-location services. 6. Do you see a need for regulatory action regarding any participants involved in colocation, i.e. firms using this service, markets providing the service and IT providers? Please elaborate. Banks have not so far been concerned about co-location services, but find CESR s research in this respect important and helpful and are open to re-evaluate their view in the light of CESR s findings. Measures should in any way be taken if there are indications about discriminative access to co-location between different market participants. IV. Fee structure Upfront, the EBF believes that exchanges and market participants should in general be as free as possible to determine fee structures in the way they consider appropriate. Restricting fee structures should not be a preferred tool for regulatory intervention. 1. Please describe the key developments in fee structures used by trading platforms in Europe. 2. What are the benefits of any fee structures that you are aware of? 3. Are there any downsides to current fee structures and the maker/taker fee structure in particular? If yes, please describe them. European Banking Federation - EBF 2010 Page 8

9 As noted above in response to Question 1 on HFT, the maker/ taker fee structure is sometimes used by HFT strategies in a way that does not add any genuine liquidity to the market. 4. What are the impacts of current fee structures on trading platforms, participants, their trading strategies and the wider market and its efficiency? While direct trading costs have decreased as a result of the greater competition that MiFID has introduced between trading platforms, indirect costs have increased. In particular, there have been increases in data costs. This is not only as a result of the need to receive data from a larger number of trading venues. For some markets including the Nordic ones, trading data can only be acquired as part of a package for several markets. I.e., a market participant might only be interested in the data referring to country X, but is forced to acquire the data for the markets X, Y, and Z. 5. How important is the fee structure of a trading platform in determining whether to connect or not to it for trading. Please elaborate. 6. Do you consider that the fee structures of trading platforms should be made public to all market participants? Please provide a rationale for your answer. The EBF is not aware of the existence of non-public fee structures and would be interested in further explanations by CESR. 7. Is there a role for regulators to play in the fee structures? If yes, please describe it. In general, banks believe that the costs for trading data need to be monitored. At this point in time, banks would also find it helpful that regulators encourage fee structures that allow market participants to acquire data in a targeted way. V. Tick size 1. In your view, what has been the impact of smaller tick sizes for equities in Europe on the bid-ask spreads, liquidity, market depth and volatility of these markets? Are there any spillover effects on derivatives markets? Overall, the sharp decrease in tick sizes has helped to reduce the bid/ ask spread. Quantities available at the best limit are lower, but there is no evidence about any negative effects on the price formation process. Up to a certain point, tick size reductions are seen as positive, allowing greater accuracy in bids and offers and reducing arbitrage opportunities for third parties. However, there are indications that from a certain point onwards, further tick size reductions rather lead to decreases in market depth and liquidity. There should therefore not be an endless race to the bottom in tick sizes. It is also important to bear in mind the positive role of spreads, as a security margin for market makers. It is natural that spreads fluctuate over time, in line with different market conditions, and in particular that they widen in more volatile market conditions. European Banking Federation - EBF 2010 Page 9

10 2. What are the benefits/downsides of smaller tick size regimes for shares in Europe? Typically, tick size reductions lead to lower spreads, which in turn is often followed by reductions in trading volume. If volumes decrease by too much, this implies increased market impact of individual orders, which can reduce the quality of markets and favour an increasing use of alternative trading platforms. 3. Is there a need for greater harmonisation of tick size regimes across Europe? Please elaborate. Banks support the initiative taken by the trading platforms to agree between them on a minimum tick size. 4. Is there a role for regulators to play in the standardisation of tick size regimes or should this be left to market forces? At this stage, the EBF does not believe that there is a need for regulatory intervention. Rather, banks support the industry initiative that has been undertaken to harmonise tick sizes. Nevertheless, it is important for CESR to continuously monitor developments. 5. Have organised markets developed an appropriate approach to tick sizes? European banks welcome the agreement that has been concluded, although developments should be further monitored. A study on the appropriateness of European tick-size harmonisation could be considered. 6. Should regulators monitor compliance with the self-regulatory initiative of the MTFs and FESE? If this initiative fails, do you see a need for regulators to intervene? In the case of failure of the industry initiative, regulatory intervention should not be automatic. Rather, CESR should continue to discuss developments with the industry to consider appropriate responses. 7. What principles should determine optimal tick sizes? Optimal tick size levels vary for different shares and can also vary for the same shares on different markets, as they can vary over time. They depend on a range of factors, including the current market price of the instrument, the trading activity in the share, average trade sizes, and the depth of order books. For the markets, they depend on the respective volatility and liquidity levels. Therefore, a delicate balance must be found in determining the right level for tick sizes across all shares in a particular market, and one size does not fit all. In turn, tick sizes that match well the market circumstances have the greatest information value for the public, i.e. they increase transparency. Changes to the current situation should only be imposed where shares are traded on more than one market place, and where the same shares are often traded on the smallest tick, with considerable depth. European Banking Federation - EBF 2010 Page 10

11 VI. Indications of interest 1. Please provide further information on how IOIs are currently used in European markets by investment firms, MTFs and RMs? 2. Which are the key benefits/downsides of such IOIs? Please provide evidence to support your views. Market operators use IOI with the intention of attracting orders. More generally, indications of interest can be beneficial in that they provide an additional tool for the establishment of levels of supply and demand for a security in the market. This should not be problematic, in the view of European banks, when IOIs are sent to a crossing engine, without being exteriorised. 3. Do you consider that MiFID should be amended to clarify that actionable IOIs should be subject to pre-trade transparency requirements? The EBF supports that this possibility is considered further. Some EBF members have suggested that IOIs should either be completely transparent vis à vis the market, or completely discrete in being released only to a crossing engine. As opposed to this, where IOIs are released to some market participants but not others, this implies a problem of information asymmetry, which in the view of the EBF is opposed to the principle of equality of opportunities between market participants. It should not be tolerated that certain information is only available to a limited number of market participants, on a discriminatory basis. 4. Do you see circumstances where it would be appropriate for IOIs to be provided to a selected group of market participants? Please provide evidence/examples to support your views. Final remark The EBF has had the benefit of reviewing the response of the Association for Financial Markets in Europe in draft. While agreeing with the general direction of their remarks, the EBF has above set out its position in its own words. European Banking Federation - EBF 2010 Page 11