Rob Daly: Saying Good-Bye to Awful 2011

One thing I’ve become intimately familiar with as a life-long fan of the Buffalo Bills American football team is the term “a building year.” I believe that 2011 has been a building year for the capital markets thanks to new regulations and rules meant to address the fallout from the 2008 credit crisis.

By mid-July 2011, the US Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) were meant to have completed writing the new rules that would regulate the over-the-counter (OTC) swaps market under the terms of the Dodd–Frank Act. But that deadline came and went, leaving firms with the long and complex task of preparing their front-, middle- and back-office systems for a new market structure whose rules are still undefined.

Although the CFTC did publicly state that its goals are to have all of the rules in place by the end of the first quarter of 2012, it’s doubtful that the regulator will meet the new deadline, given the amount of heavy lifting that remains in defining the new market practices. At best, the US regulators might fall in line with the other Group of Twenty (G20) market regulators that have set the end of 2012 as the deadline to centrally clear these products.

Take Two
Europe should not feel left out in regulatory disappointment. The release of the review of the Markets in Financial Instruments Directive (Mifid II) demonstrates a basic lack of understanding of how to regulate high-frequency trading. The European Commission’s intentions to prevent algorithmic trading engines from creating  or contributing to “disorderly trading conditions on the market” is rife with unaddressed issues, especially how it defines what high-frequency trading is. It proposes that markets use a ratio of executed and canceled trades, but it does not state what that ratio should be or who should determine it.

In the US, the SEC has taken a few steps to rein in high-frequency traders and their impact on the market. First, it has harmonized the circuit breakers on the US stock exchanges to prevent a repeat of the Flash Crash. It was a good move to address systemic risk in such a fragmented market, even though high-frequency trading was not the specific cause of the crash.

At press time, the SEC’s Rule 15c3-5, which requires pre-trade risk checks for broker-dealer clients that are trading via sponsored direct market access (DMA), was set to take effect. The rule seems to be a no-brainer for the brokers sponsoring their clients’ access as well as the market as a whole because no one benefits when traders go rouge.

Yet this seems to be a preemptive strike. I am not aware of a single trading situation in the market that the SEC can use as a precedent for this rule. It also seems, as I have mentioned in the past, half a standard, since the CFTC has not issued a similar rule. Given that many firms are trading multi-asset strategies, doing a risk check only on equities and equity options seems a bit short-sighted. Reading the rule, one is left feeling that the regulators would eventually like to see real-time synchronous cross-margin credit checks performed by the broker-dealers. Knowing the state of risk management systems, the regulators should expect to see asynchronous risk checks based on the individual lines of business.

Shrinking Budgets
Firms would love to have real-time risk-check capabilities across the enterprise, but much of the shrinking IT budget is tied up with keeping the lights on and preparing for the 90-day implementation period once the CFTC and SEC finalize the Dodd–Frank rules.

It would be nice to believe that the regulatory environment will change in the new year, but with the spectacular flameout of MF Global, Pipeline Trading’s troubles, and the growing popular discontent as embodied by Occupy Wall Street and its regional siblings, regulation and over-regulation will be the norm in 2012.