In the exchange business, nobody cheers when another exchange has an outage. It could be you next. Nobody celebrates when an errant algorithm causes a broker to go bust on someone else’s market because the shock waves may reverberate uncomfortably close to home. Whilst robust capital markets are clearly in everyone’s interest, electronic trading errors and trading interruptions are a fact of life. They are an unavoidable consequence of the highly-competitive and fast-moving environment in which financial markets now operate. Reducing the risks will require concerted and coordinated action from the market players and the exchanges themselves, and a new paradigm in regulation.
As most sector observers will no doubt agree, the origins of today’s challenges can largely be traced back to the introduction of Regulation National Market System (Reg NMS) in the US and the Markets in Financial Instruments Directive (MiFID) in Europe almost a decade ago. Prior to this, exchanges were largely operated as detached national monopolies and, as such, were able to take a rather conservative approach to the resilience of their trading platforms. Each instrument was traded on one venue, so trading firms didn’t need to be so smart. Life was simple.
But as markets fragmented and competition started to increase in the US and Europe, exchanges around the world naturally started to become more aggressive. Speed and capacity became the name of the game and latency became Enemy Number One as exchanges vied to take the next step in the ‘race to zero’. At the same time, exchanges became interconnected, creating additional complexity, and the rate of innovation also increased. Exchanges started to compete on the basis of their technology rather than their reliability.
Today’s exchange operators are more concerned about the fight for survival where the risk of outages must be balanced against the opportunity cost of losing the competitive edge.
As a result, most exchanges have essentially been forced to shift their emphasis away from the pure objective of providing a stable and reliable capital market infrastructure; today’s exchange operators are more concerned about the fight for survival where the risk of outages must be balanced against the opportunity cost of losing the competitive edge.
It is not just exchanges where these distorted interests exist. The term ‘risk arbitrage’ is used where clients give business to the intermediary offering the least risk management because less overhead means lower latency. And in an environment where yesterday’s killer algorithm can be mauled to death today by a competitor algorithm, bosses at trading firms are not going to be overly well disposed to requests for another week of testing before the next version is launched.
We have reached a point where significant sections of the global financial market infrastructure are incentivized to sail as close to the wind as possible. Perhaps we should only be surprised that more crashes don’t occur. Somehow, the whole industry needs to navigate its way to a new paradigm where players do not compete on safety.
The airline industry competes on price, speed and quality of service, but it operates under an internationally adopted set of safety standards. These standards evolve over time in response to incidents and also advances in technology. The finance industry may not have responsibility for human life, but we have responsibility for life savings, so there is no reason why we can’t adopt similar principles.
While competition and the pace of innovation continue to rage unyieldingly, I believe that we have now turned a corner where all stakeholders – from intermediaries and traders through to regulators and exchange operators – are starting to recognize the value and importance of creating a more reliable and stable financial highway. The crisis of confidence within the public from too many incidents is too hard to ignore. Making progress to restoring confidence, however, will take heavy lifting and will require the industry as a whole to come together to tackle risks at all levels.
Regulation and regulators are key. Regulators, in making the laws of the road and policing their implementation, are uniquely positioned to create a level playing field in risk management. But to be effective in building defenses against errors and measures to prevent outages, regulation needs the involvement of everyone in the industry. Regulation also needs to be clear. The principles-based approach typically favoured by regulators has advantages such as providing flexibility towards achieving a desired outcome, but it lacks certainty. When it comes to safety, there should be no uncertainty. What is needed is a combination of principles based regulation together with specific rules.
Public confidence in capital markets is at an all-time low. With competition and the pace of innovation continuing to rage unyieldingly, the risks are not getting smaller. Now is the time to work together to take a more holistic view and ensure that, at every level, we are creating, implementing and monitoring the appropriate checks and balances to make markets safer and more reliable.
Julian Ragless is the Managing Director of Platform Development at the Hong Kong Exchanges and Clearing (HKEx) where he is responsible for aligning technology and strategy to meet the organization’s business objectives. Prior to this, Julian served as Vice President of Exchange Solutions at NYSE Technologies. The views expressed in this article are his own and do not necessarily reflect the views of HKEx.
Partner, KPMG in China
Managing Director at HKEx
As Julian notes above, many organizations today struggle to find the right balance between two major priorities: the need to deliver stable and resilient platforms versus the desire to be first to market with new products or faster services, and exchanges are no different. Not surprisingly, this has led to many organizations focusing on shortening the development phase of their projects which has, in turn, had a direct impact on project planning, testing, rehearsals and drills. Add to that the increasing risk of cyber issues inherent in any highly-automated platform, and we firmly believe it can only be beneficial for exchanges to work together and spend time exploring that fine balance between resilience and timely new technology.
Henry Shek, Partner, KPMG in China
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