Market participants have seen an unprecedented period of structural and regulatory change in Australian financial markets over the last two years.
This has been driven by a combination of factors - the introduction of financial market competition, ASIC assuming responsibility for the supervision of licensed markets and the rapid rise in the importance of trading technology. All this has come during a time of very challenging trading conditions and consequent revenue constraints, while costs for market participants have continued to rise.
As 2012 draws to a close, it is an opportune time to reflect on some of the key changes faced by market participants, and what lies ahead.
Cost recovery for ASIC market supervision
The legislation allowing ASIC to recover its costs of market supervision from market participants and market operators became law in 2012. The initial levy for market participants totals approximately $23 million, to be recovered over the 18 month period from 1 January 2012. ASIC’s non-IT costs are allocated to participants based on the number of transactions executed or reported. IT costs are allocated based on the number of trading messages generated by participants.
It is not surprising that industry raised concerns with cost recovery given the difficult market conditions. Concerns were raised over whether ASIC imposed appropriate expenditure controls in its market supervision projects, and whether the trading messaging component of the levy would unfairly impact on certain categories of market participants and reduce liquidity in the market. In response, the Government has established a Cost Recovery Stakeholder Panel to provide stakeholder perspectives on ASIC’s future market supervision projects and approaches to cost recovery.
The cost recovery will contribute towards funding the replacement of ASIC’s current electronic market surveillance system with an enhanced system better placed to deal with the significantly increased volume of algorithmic and high frequency trading.
Best execution - the best outcome across multiple trading venues
A fundamental component of the introduction of competition between financial markets in Australia was a “best execution” obligation for market participants. Market participants are required to take reasonable steps when handling and executing an order in equity market products to obtain the best outcome for the client. For retail clients, the best outcome means the total consideration, taking into account client instructions. For wholesale clients other outcomes may be relevant, such as speed and likelihood of execution. Quite apart from forming a view on what “reasonable steps” means and devising appropriate policies and procedures, market participants have been faced with significant practical implementation issues. A best execution policy was required to be prepared and provided to clients, with many participants having to make multiple disclosures to clients as policies were fine-tuned or new trading venues accessed.
The best execution obligation requires an assessment of all order books of all licensed markets. It could therefore potentially require a market participant to be capable of transmitting orders to multiple trading venues, not just ASX’s TradeMatch1. This clearly has significant resource and systems implications for market participants. In recognition of this, a transition period is currently in place until 1 March 2013. The transition period allows ASX participants to nominate to transmit orders only to ASX’s TradeMatch. Before the end of the transition period, participants will need to assess whether other order books (including Chi-X) consistently deliver better outcomes, connect to those other trading venues if this is the case, and develop policies and procedures to direct orders to the appropriate trading venue.
Future of Financial Advice reforms
Like the rest of the financial services industry, the Future of Financial Advice reforms (FoFA) are requiring a significant investment of time and energy for market participants, especially for full service brokers. The mandatory compliance date of 1 July 2013 is fast approaching and there is much to be done. Moving to a model where clients are asked to pay directly for the advice they receive, rather than indirectly through commissions paid by product manufactures and others, is a huge logistical and philosophical shift. Staff incentive models are also having to be re-designed.
While it is difficult to argue against the philosophy of FoFA, market participants have lobbied hard on three critical issues for the stockbroking industry – to allow stamping fees, brokerage splits and scaled advice.
On 22 November 2012 final regulations were released covering stamping fees and brokerage splits. Stamping fees are charged by brokers to listed entities when their clients invest in a capital raising by the listed entity, and are an important feature of the public securities market.
The new regulations will allow stamping fees to be charged in relation to a broader range of financial products than first announced, although the carve out applicable to “investment entities” is a significant limitation. It means that the REIT sector will not have the benefit of the stamping fees exemption. There is also a concern that the exemption would not apply where stamping fees are paid by an underwriter as principal to a broker, rather than by or on behalf of the issuer of the securities.
The regulations will allow market participants to pay up to 100% of the brokerage fees received from clients to employees/advisers for market traded products. A general concern, however, is that the ban on asset based fees on borrowed amounts may impede the operation of the exemptions where investors purchase securities through margin loans.
Although they are not without their limitations, the stamping fees and brokerage split exemptions are significant wins for market participants.
“Scaled advice”, where the subject matter of the advice sought by the client is limited (eg to market quoted equities), is very common in the stockbroking industry. It is critical that the statutory “best interests” obligation in FoFA adequately caters for this kind of advice. There has been some progress on this issue, as the possibility of scaled advice is now referred to in a note in the legislation, although there is a significant body of opinion that a note is not adequate given the express provisions of the best interests obligation. ASIC has also issued a consultation paper dealing with scaled advice.
Pre-trade transparency rules
Pre-trade transparent or “lit” markets provide information on bids and offers before transactions are executed. Many believe that pre-trade transparency is central to the fairness and efficiency of markets, particularly liquidity and price information.
The subject has received considerable focus both in the context introducing competition between financial markets and the increasing prevalence of “dark pool” trading venues. Several changes have been proposed, with some implemented. A clear objective has been to harmonise ASX’s pre-trade transparency exceptions across all markets.
One important change has been the introduction of an “at or within the spread” exception to pre-trade transparency. It allows a transaction to be executed outside the market’s order book where it is at or within the spread of the best available bid and offer at the time available across all pre-trade transparent order books. In mid-2013 a meaningful price improvement rule will apply for trades that are not pre-trade transparent, and a tiered threshold will be introduced for the block trade exemption to pre-trade transparency.
Suspicious transaction reporting
From 20 January 2013 market participants will be required to comply with a new obligation to report suspicious trading activity to ASIC. The reporting obligation will arise where the participant has reasonable grounds to suspect that a person has placed an order or entered into a transaction while in possession of inside information, or is involved in market manipulation, false trading or market rigging. Again, this new obligation requires new systems and procedures, as well as training. Helpfully, ASIC has provided confirmation that it “does not expect a market participant to actively seek to detect reportable matters …. Rather, the rule requires market participants to report activity they become aware of in the ordinary course of their client and proprietary trading activities”2. Further, ASIC will take into account whether “information has in fact come together” within an organisation in determining whether a reporting obligation has arisen. This addresses the difficulty that information may be held within different parts of a market participant’s business, and only if that information was to come together would it give rise to reasonable grounds for suspicion.
Short sale tagging and other record changes
Commencing during 2014, market participants will be required to enter additional data in orders and/or trade reports, to enhance ASIC’s surveillance ability. The data will include a client identifier or reference, identification of any licensed intermediary and whether a trade for a wholesale client was facilitated through direct market access. In addition, short sale orders will need to be tagged as such when transmitted to the market, and this obligation is anticipated to replace current daily short sale transaction reporting to market operators. While these changes may seem minor on their face, their systems implications are considerable.
High frequency and algorithmic trading – rule changes and task force announced
There is no doubt that the importance of technology in trading on financial markets has increased significantly over recent years. This has been matched by intense interest in the subject from regulators, commentators and the media. Unfortunately, some commentary has been emotive, and even misconceived. Algorithmic trading and high frequency trading (HFT) have sometimes been treated as interchangeable terms, which is not correct. Algorithmic trading has been a feature of our market for many years, and often involves uncontroversial trading strategies such as VWAP (trading to achieve the volume weighted average price). While there have been instances of algorithmic trading programs malfunctioning and causing market disruption, the trading strategies themselves are not necessarily objectionable.
HFT is a subset of algorithmic trading and can involve placing, amending and cancelling high volumes of often small orders, with only a portion of the original orders being executed. The objective is to profit from small price movements through sophisticated strategies, and the ability to place, amend and cancel market orders at extreme speed is critical to achieve this. The potential for market manipulation is present, particularly if a HFT strategy involves placing of orders with no intention of execution. Again, however, HFT involves a wide spectrum of strategies and it is unwise to make broad generalisations.
On 21 November 2012, ASIC announced a number of important rule changes for algorithmic trading and HFT:
- new rules to require direct control over trading algorithms by market participants, including “kill switches” to immediately stop an algorithm if it is interfering with the efficiency or integrity of the market; and
- rules requiring market operators to tighten controls over extreme price movements.
These rules will become effective during 2014. They continue the theme of rules placing strict responsibility on market participants for the orders they place, including where orders are placed by clients through the participant’s direct market access platform.
ASIC has also announced an HFT taskforce, which will deepen ASIC’s understanding of HFT and consider whether further controls on HFT are required. ASIC has flagged reconsidering order to trade ratios, and minimum order and tick sizes. The task force will also consider whether certain HFT strategies should be prohibited and if new rules on market manipulation are required.
Dark pools - rule changes and task force announced
Like electronic trading, so-called “dark pools” have been the subject of significant regulatory focus. Dark pools are trading venues which operate away from the transparency of “lit” markets such as ASX TradeMatch. In addition to new rules on price improvement and block trades, on 21 November 2012 ASIC announced that a task force has been established to consider dark pools. It is expected that the taskforce’s findings will inform the Government’s recently announced review of the Corporations Act markets licensing regime. The markets licensing regime has direct relevance to dark pools, as there has been an on-going debate over whether dark pools should be regulated as a service rather than a market, or alternatively under a suitably “scaled” markets licensing regime.
This article has outlined only a sample of the changes faced by market participants over the last two years. Now that the framework is in place for competition between financial markets, and ASIC’s supervision of financial markets, there is hope that this volume of changes will not be repeated over the next two years.
It seems likely that the key areas for reform in 2013 will relate to the regulation of dark pools, algorithmic trading and HFT. The Discussion Paper released by Treasury recently on competition in clearing and settlement raises the prospect of yet another fundamental reform for market participants, although perhaps on a more extended time frame.