Financial Regulatory Forum

Europe exchanges’ pre-trade safety seen at risk

By Reuters Staff
May 10, 2010

By Jane Baird

LONDON, May 7 (Reuters) – The safety systems of Europe’s stock exchanges are at risk of being eroded by market pressures and experts say regulators need to act to head off a computer-driven tailspin like the one that hit U.S. stocks on Thursday.

Europe’s big exchanges are still less vulnerable than their U.S counterparts to error-induced convulsions similar to the Dow Jones Industrial Average’s nearly 700 point drop in 10 minutes, but a race for speed is pressuring them to weaken their safety controls

“European exchanges are being forced by commercial pressures to slim down their platforms and show faster and faster trade times, which means they are at risk of eventually cutting off their circuit-breakers. Meanwhile, there are no regulatory counter-measures to pre-empt it” said Frederic Ponzo, a managing partner at Greyspark Partners.

The European Union is reviewing its share trading rules, known as markets in financial instruments directive (MiFID).

The bloc’s securities regulators opened a probe in April into whether MiFID should be changed to include regulation of new technology such as high-frequency trading.

The London Stock Exchange has circuit breakers built into its electronic order book that stop trading if a price jumps more than a certain percentage in a trade.

That limit, which depends on the typical liquidity and volatility of a particular stock, is around 3 percent for highly traded stocks, an LSE spokesman said.

The stock then goes into an auction for around five minutes, giving market participants time to spot an error.

The SIX Swiss Exchange has circuit-breakers for excessive price moves — either from one trade to the next or for a series of trades over a period such as 10 seconds — that halt all trading for a few minutes.

The exchange furthermore has an active policy of then contacting the member firms involved to check on the trades.

“We have risk management to catch both manual and electronic errors,” said Chief Executive Christian Katz.

LEGACY VS SPEED

European exchanges have a longer history of trading electronically than U.S. markets and a legacy of implementing safeguards, while the newer U.S. systems are trimmed down for faster trading, Ponzo said.

“In Europe, the technology and risk management approach in place would have spotted these (erroneous) transactions or sent an alert to the financial institution involved,” said Axel Pierron, senior analyst at research and consulting firm Celent.

“The surge to reduce latency on execution platforms in the United States has pushed them toward removing some of the safety features,” Pierron said.

But increasing demand for instantaneous trading is now driving Europe’s trading platforms also to cut trade turnaround time, known as latency.

While exchanges account for the majority of trading, high-frequency trading and rival multilateral trading facilities (MTFs) have rapidly grown to 30-40 percent in recent years.

The LSE spokesman said the exchange remains the price formation venue for UK stocks and that prices on MTFs, either directly or indirectly, are pegged to it.

“It is unlikely that this kind of dramatic drop could happen in the UK,” he said.

But Katz said MTFs have big members who trade Swiss stocks and do not trade on the exchange. Even if SIX heads off a major distortion, that does not prevent a problem on an MTF, he said.

“The MTF competition has not necessarily made European markets a safer place,” he added.

The leading MTFs such as Chi-X Europe and BATS are based in London, where the Financial Services Authority (FSA) requires them to employ pre-trade checks and circuit-breakers.

They typically will not accept an order whose price is 20 percent away from the reference price on a primary exchange. But the standards vary from one market to another.

“There is a need for guidelines that are quantified, not just qualitative,” said Greyspark’s Ponzo.

“The MiFID review is an opportunity to create consistent standards across trading platforms,” said Hirander Misra, chief executive of ALGO Technologies and former Chi-X executive.

(Additional reporting by Huw Jones; Editing by Erica Billingham)

((jane.baird@thomsonreuters.com, Reuters Messaging: jane.baird.reuters.com@reuters.net, +442075422471))

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