As financial institutions bemoan the uncertainty still hovering over Dodd-Frank implementation and possible delays, there are steps that they can take to prepare for them even before the ink dries. Otherwise compliance can cause major disruptions to their business operations.
Brokers, in particular, cannot afford to wait to protect themselves and their clients from market risks, and from running afoul of shifting market regulations. Attracting new clients – and retaining existing clients – will depend increasingly upon whether a broker has measures in place to protect a client’s interests.
Dipping an unprotected toe into a market where a flash crash can happen at any moment can be frightening. This is not scaremongering, it is the market today; insider trading and market manipulation can happen within the best of trading firms. And algorithms allowed to run without proper controls can take a company’s balance sheet from black to red, or worse. The debate around the notion of regulators reviewing algos before they go to market (see Larry Tabb’s article and resulting commentary here) is a clear indication of nervous market sentiment (no Twitter trading analytics required).
Regulators are laying miles of new tracks (rules) for high-speed and heavy freight trains running through the electronic trading frontier, and they are preparing to make sure the trains stay on the tracks. Trade monitoring, auditing, and abuse prevention requirements abound throughout the proposed rules, including recent efforts to detect market manipulation. But there is little reason for financial firms to wait for strict definitions of what “sufficient” measures are in a market that continuously gives us examples of what to detect, prevent, and deter.
By gaining real-time visibility to potentially abusive and erroneous trading activities, brokers can quickly pinpoint threats. But brokers need to constantly adapt detection scenarios to new threats; and they also need to tailor their responses and modify them without disrupting their trading operations. Responsiveness is more than lightning-quick reflexes. Flexibility is also key; and is what will transform regulatory compliance into competitive advantage now and into the future.
Despite complaints, media interest and suggestions to the contrary, algorithms and high frequency trading are not going away. When problems such as crashes or abuse occur it is partly because regulators have not yet had the chance to get a uniform, industry-wide grip on how long-standing underlying market practices manifest in the new, high-speed environment, and how compliance departments should monitor them.
HFT is not necessarily the culprit; market structure must also be questioned. High frequency trading shops often act as de-facto market makers. During the flash crash some HFT’s algorithms sensed a problem and pulled out. If HFT’s have replaced traditional market makers, why have the market making obligations not carried over? And should they? Now we must ask who – if anyone – should have an obligation to stay in the game when things go wrong, and the eventual answer will change market participants’ business models.
Human beings continue to possess attributes that computers cannot. But the human intelligence to slow things down in times of stress, or provide real liquidity in a two-sided market – not just volume – is a decision that can be automated. This is necessary, in fact, because humans can’t step in fast enough in today’s hyper-speed markets. Therefore, financial organizations have no choice but to use technology and applications that ensure compliance, though not at the expense of efficient trading operations. This kind of technology enables firms to be compliant in new ways, including transparency and reporting.
The ability to detect abuse and operational errors in real time, along with the flexibility to modify scenarios in response to new conditions, while staying ahead as regulations change, differentiates a broker competitively. The buy side wants safety in the marketplace, and it is up to the sell side to make sure their buy side customers feel secure.
New regulations bring new headaches to organisations as they have to add or change both applications and operations to comply. Having the ability to sense threats, and to respond in real-time, is just the compliance “price of entry” to the market today. Being able to comply with new mandates quickly is the differentiator, and there will be no shortage of surprises in store as the regulatory trains rumble towards an unknown destination.