Over a relatively short period, the regulation of financial markets in Australia has seen both fundamental structural changes and reforms which will impact on how financial markets operate on a day-to-day basis.
There are a number of forces behind these changes - the drive to achieve competition between domestic financial markets, increasing globalisation of financial markets, concerns arising out of the GFC, and an unprecedented increase in the importance of technology in trading on financial markets. There seems to be a common understanding that this is not an area in which we can afford to be complacent, without the risk of relegation of our markets to irrelevancy.
While our response has been encouraging, there are a number of important challenges ahead. These include an appropriate regulatory response to electronic trading systems known as “dark pools”.
What has been achieved so far?
The first major development in achieving competition between financial markets occurred in August 2009, when the Government announced that ASIC would take over the supervision of real-time trading on Australia’s domestic financial markets. ASIC assumed that responsibility in August 2010, following a significant capability build, including adopting the “SMARTS” electronic market surveillance system and taking on staff from the ASX’s market surveillance team. It is hoped that this change will significantly reduce the time taken to investigate and prosecute serious market misconduct. The previous two step process of initial investigation and referral to ASIC by ASX, then further investigation and prosecution through ASIC, has been eliminated. The first insider trading case to run its course through the new system was resolved in July 2011, when an employee of a share registry group pleaded guilty to insider trading arising from inside information relating to a number of recent corporate deals.
In July 2010, ASIC established a new Markets Disciplinary Panel to act as the peer review body for brokers, with the power to issue infringement notices and accept enforceable undertakings relating to breaches of new market integrity rules. The Panel has taken over the functions of the ASX Disciplinary Panel, which will continue to deal with cases relating to conduct that occurred before the hand over of responsibility to ASIC. The new Panel is yet to make its first determination, and it is too early to say whether it will achieve its aim of reducing the time to determine matters from an average of one year and five months under the ASX system to nine months.
To support these developments, the rules governing the operation of domestic licensed markets have been restructured and, to an extent, rewritten. Operating rules administered by the ASX for its markets have been split into two sets of rules - one set of operating rules administered by the ASX and a set of “Market Integrity Rules” administered by ASIC and the Markets Disciplinary Panel. The most recent development has seen the incorporation of the capital requirements applicable to brokers into the ASIC Market Integrity Rules.
By and large, these changes have sought to maintain the status quo in terms of how the rules operate, whilst transferring responsibility to ASIC. There are, however, a number of changes incorporated in the ASIC Market Integrity Rules (Competition in Exchange Markets) 2011, which will have a significant impact on the way licensed markets and brokers operate, and the bulk of these rules are set to commence on 31 October 2011. The important changes include:
- like a number of other major markets, market participants will now be subject to a “best execution” obligation, being an obligation when handling and executing client orders to take reasonable steps to obtain the best outcome for the client. For retail clients, this will require brokers to obtain the best price taking into account transaction costs. For wholesale clients, other factors can be taken into account, such as speed of execution. Subject to a transition period, brokers will need to take into account trading on licensed financial markets competing with ASX and consider whether it is necessary to become a participant of those other markets;
- market operators will be required to have in place controls which minimise the risk of an order executing at an anomalous price. These rules are designed to avoid extreme price movements, such as those that occurred in the United States during the May 2010 “flash crash”;
- consistent new pre-trade transparency rules across licensed markets have been introduced, which will impact on when brokers can arrange trades (or “crossings”) other than by matching of an order on an order book. Unless another exception applies (eg for large block trades), the trade must be at or within the spread of the best available bid and best available offer at the time; and
- in recognition of the role electronic trading systems, brokers are required to notify ASIC of the “crossing systems” they operate and to comply with monthly reporting requirements relating to those systems.
All these changes will mean that a framework will be in place from 31 October 2011 to allow Chi-X to become the first licensed market to compete with the ASX in Australia.
Dark pools - the next challenge
As part of these reforms, the regulatory spotlight has been focussed on a number of emerging trends. These have included “high frequency trading” and “algorithmic trading”, where high speed computer systems are used to generate, route and execute orders on markets. Similarly, so called “dark pools” have generated significant attention. Essentially, a “dark pool” is a trading facility where orders relating to exchange traded products can be executed away from the market on which the products are traded. A typical example is an electronic trading system operated by a broker which allows orders from the broker’s professional investor clients to match one another, without being routed to the market in question. Dark pools are variously known as “crossing systems”, “alternative trading systems”, “electronic communication networks” or “multilateral trading facilities”. They provide for more efficient execution of larger orders from professional investors, which might otherwise have a material market impact if executed through the market’s transparent order book matching process.
Under the Corporations Act, the definition of “financial market” is so broad that electronic trading systems call easily require a full Australian market licence in order to operate in Australia, unless an exemption is available. We are therefore faced with a regulatory system which is built on the assumption that the full range of market regulatory controls should be imposed on these electronic trading systems. This is out of step with the way these facilities are regulated in a number of developed markets and does not take into account features which differentiate them from public markets. There are strong arguments in favour of a “scalable” approach to the regulation of electronic trading systems:
- typically these systems are only available to professional investors, which do not demand the full range of protections appropriate for retail clients trading on public markets;
- despite the evocative terminology, “dark pools” are essentially an electronic extension to the voice brokerage (or “client facilitation”) services that have always been available to professional investors;
- electronic trading systems usually operate within the bounds of the rules of licensed markets, including the rules governing pre-trade transparency and reporting. Under the rules of the market, for example, a broker may only be permitted to pre-arrange a transaction between two clients if the value of the trade is at least $1 million.
In Europe, “multilateral trading facilities” (MTFs) are differentiated from regulated markets under the Markets in Financial Instruments Directive (MiFID). While pre-trade transparency and other requirements apply, MTFs are not regulated as full financial markets. A similarly scalable approach is applied to “alternative trading systems” in the United States.
Our existing regulation does allow financial markets to be granted conditional licence exemptions on a case-by-case basis. To date, however, these exemptions have focussed on specialised financial products which are not traded on public markets.1 Further, the exemption process has proved both time consuming and expensive, partly because it involves a two step process under which ASIC must formulate a recommendation for consideration by the Treasurer. What is required is a transparent and certain set of rules under which electronic trading systems can operate.
The regulation of financial markets in Australia has developed rapidly over the last three years. The policy objective of competition between markets, and responses to the GFC and emerging trends, have all been addressed in some way.
There is of course more work to do, and with increased globalisation the stakes are high. In fact, a proactive and innovative approach is required if our markets are to be attractive to offshore investors and market participants.
Among the challenges is to create a scalable regulatory regime which is appropriate for electronic trading systems or “dark pools”. Current indications are that Treasury will release a paper on the subject later in 2011.