In much the same way that the global financial crisis alerted policy-makers to a host of regulatory vulnerabilities, last year’s so-called “flash crash” is proving to be a signal event in the equities trading arena. Regulators are now moving to address the emerging risks they’re seeing with the evolution of electronic trading.

Market structure has changed dramatically in the past few years with the introduction of multiple marketplaces, relentless innovation and competition among those markets, as well as the rapid rise in trading volumes and data traffic amid an escalating electronic-trading “arms race.” It appears the trading environment is evolving well beyond a regulatory regime that was designed for a different era.

The brave new world of equities trading is challenging regulators in two ways. At a technical level, the new climate is stretching their ability to watch over the market. For example, the Investment Industry Regulatory Organization of Canada reports that the rise of algorithmic trading and high-frequency trading has “caused a dramatic increase in the volume of daily messages along with a sharp increase in order-to-trade ratios. These increases have challenged our resources.”

IIROC reports that in 2010, it monitored more than 262 million trades, double the total of a couple of years ago; and IIROC now also monitors between 150 million and 200 million messages a day on average, up from 10 million just four years ago. Given forecasts of ever-rising message volumes, IIROC is investing in surveillance systems to increase its processing capacity to one billion messages a day.

At the same time, the new trading climate is giving rise to new risks, including systemic risks. The global financial crisis first put regulators on alert for systemic risks (something that has not traditionally been a concern for them); then the “flash crash” demonstrated that these types of risks may materialize as a consequence of evolving market structure, too.

The May 6, 2010, flash crash occurred when the Dow Jones industrial average plunged by about 900 points but recovered those losses in minutes. U.S. regulators found that HFT greatly exacerbated the downturn of stock markets already jittery over the debt cris in Greece.

In Canada, the S&P/TSX composite index fell by more than 450 points but recovered to finish down just 0.2% on the day. IIROC’s review found that after the big drop in U.S. markets, high-frequency traders quickly pulled out of the Canadian market, “causing a dramatic and rapid decline in available liquidity.”

In response, regulators have launched a variety of initiatives to try to keep up, including the introduction of new circuit breakers, enhanced guidance on the use of certain order types and a review of policies for dealing with erroneous trades — along with proposals for handling “dark” liquidity.

The latest effort from the Canadian Securities Admin-istrators addresses electronic trading. In early April, the CSA proposed a rule that will impose new requirements on markets (both exchanges and alternative trading systems), dealers and traders that are designed to curb some of the risks associated with the increasing prevalence of electronic trading — particularly HFT that relies on unfiltered access to the market. Direct-market access enables traders to enter orders directly on markets without passing through any of the pre-trade controls or filters that would apply to orders submitted via a dealer’s systems.

By all accounts, HFT has become increasingly common in recent years. Certainly, that can be inferred from the large increase in both trading volumes and message traffic. IIROC says it has begun a study of the volume of electronic trading and HFT that is occurring in Canada but is at an early stage and doesn’t have any results yet.

Still, according to one estimate, HFT accounts for about 35% of all equities trading in Canada and for 50% in the U.S. More worrying, about 20% of all trading in Canada, and 35% in the U.S., is estimated to represent so-called predatory trading strategies that don’t add genuine liquidity or improve market quality but can impose added trading and infrastructure costs on the rest of the market.

The CSA’s proposed rule isn’t designed to stamp out predatory trading. Although these strategies may be indirectly affected by the proposals, regulators are seeking to curb what they see as growing risks associated with direct market access trading in particular and electronic trading generally.

“This proposal is designed to establish a regulatory framework,” says Susan Greenglass, director, market regulation, with the Ontario Securities Commission, “to ensure that marketplace participants and marketplaces are managing the risks associated with electronic trading, including direct electronic access, which is important to maintain investor confidence in our markets.”

Regulators are worried that several of these risks are threatening market integrity, and that they could evolve into systemic risks.

For example, the CSA warns that there could be uncertainty over just who is liable for regulatory violations or market disruptions caused by direct market access trading — the dealer that has facilitated access to the market, or the trader; and that, as electronic trading gets faster, the danger of these sorts of issues increases as well. Regulators want clarity as to who will be held responsible for ensuring these risks are monitored and controlled.@page_break@Similarly, regulators are worried that as trading gets faster, credit risks rise as well. Orders entered without any controls could put a trader in the position of exceeding his or her credit limits because either the trading activity is too fast to track or the high speed of trading leads to more errors. This, in turn, could represent a systemic risk, the CSA says. If a dealer is unable to settle its trades, and it fails, the impact of that failure could reverberate throughout the market.

The risks of direct market access are amplified by the possibility of a trader delegating his or her access to another entity, which puts the origin of trading activity even further from scrutiny.

The CSA worries that this could mean that the dealer that is facilitating direct access can’t identify or verify the suitability of the trader; and that the dealer may not have recourse against that trader if a problem arises. This situation could both hurt the affected dealer and harm market integrity.

The CSA also sees risks associated with an increasing reliance on technology and the interconnection of systems necessary for high-speed electronic trading. The CSA suggests that the impact of systems failures, capacity shortages, programming errors or mistaken trades can cascade through the market in the current environment.

In addition, such failures could undermine market confidence, particularly when they lead to regulators cancelling or varying trades (as they did in the wake of the flash crash).

Finally, the CSA also sees a risk of regulatory arbitrage if rules in Canada concerning electronic trading and direct access aren’t consistent with global standards, particularly U.S. standards. (Last year, the U.S. Securities and Exchange Commission introduced rules banning unfiltered market access.)

Concerns about the possible effects of direct market access are not entirely new. In 2007, the CSA proposed amendments to deal with direct market access, but those changes were never implemented. Instead, the only rules governing these arrangements have been adopted by individual markets. However, there is no consistency to these rules among markets; nor do they adhere to a minimum standard.

And since the regulators last considered rule-making in this area, the risks associated with unfiltered access have become harder to ignore. As the CSA paper notes, events such as the flash crash have “illustrated that the speed and complexity of trading require a greater focus on controls designed to mitigate the risks of these technological changes.”

Therefore, the CSA has decided new rules are needed that expand the 2007 proposals and seek to regulate electronic trading generally, not just direct market access trading. The new rules would require market participants (such as dealers) to ensure all order flow is monitored and subject to pre-trade controls designed to prevent orders that exceed credit or capital limits, ensure compliance with regulatory requirements and prevent erroneous trades, among other things.

The CSA also seeks to also impose requirements on marketplaces to supplement the dealer requirements and act as another layer of protection against electronic trading risks, including a requirement to prevent “fat finger” (inadvertently large) trades.

In addition to the requirements that will apply to all electronic trading, the proposed rules also impose a specific framework on direct access trading.

Essentially, the proposal would make dealers that facilitate direct market access responsible for any trading that takes place under their names, and would require dealers to establish standards (in financial resources, proficiency requirements and compliance capabilities) for clients that use the facility. The proposal would also set limits on the trading of direct market access clients as well.

Under the proposed rule, only IIROC dealers could provide direct market access, and only IIROC dealers or portfolio managers could be direct market access clients; exempt-market dealers would not be allowed to be direct market access clients.

However, the proposed rule also would allow individuals to be direct market access clients. The CSA says that although retail investors should not be trading this way, it believes there may be circumstances in which individuals are sophisticated enough and have access to the necessary technology for this sort of trading (such as former registered traders or floor brokers).

Ultimately, these proposed measures should help insulate the overall market from some of the risks that have arisen alongside increased electronic trading, but they’re not expected to turn back the clock on the trend toward ever-faster, higher-volume trading.

According to a report from TD Securities Inc. of Toronto, the CSA proposal may push HFT firms to register as dealers themselves. “This will impose a certain regulatory burden on these firms, but will ultimately have minimal impact on their operations,” the report suggests, adding that the proposed rules aren’t likely to have a big impact on the pattern of trading.

To the extent that certain HFT strategies are seen as harmful to the market, the CSA’s new proposal aren’t likely to do much to curb that harm. IE