The Responsible Way to Rein in Super-Fast Trading - by Gary Cohn

The Responsible Way to Rein in Super-Fast Trading. By Gary Cohn
At Goldman Sachs, we would back these measures to limit the risk and instability that technology gains brought.
WSJ, March 20, 2014 8:05 p.m. ET
http://online.wsj.com/news/articles/SB10001424052702303563304579447692855042948

Equity-market structure in the U.S. has made important advances over the past 20 years, promoting greater transparency and liquidity. Three powerful forces have been at work: technology, regulation and competition. The result has been narrower spreads, faster execution and lower overall explicit costs to trading stocks.

With the overwhelming majority of transactions now done over multiple electronic markets each with its own rule books, the equity-market structure is increasingly fragmented and complex. The risks associated with this fragmentation and complexity are amplified by the dramatic increase in the speed of execution and trading communications.

In the U.S., there are 13 public exchanges and nearly 50 alternative trading systems. Regulation NMS (National Market System), adopted in 2007, requires that market participants route their orders to the exchange that displays the best public price at any given time. This has increased both the number of linkages in the market and the speed at which transactions are done. The Securities and Exchange Commission has correctly called for an "assessment of whether market structure rules have kept pace with, among other things, changes in trading technology and practices."

In the past year alone, multiple technology failures have occurred in the equities markets, with a severe impact on the markets' ability to operate. Even though industry groups have met after the market disruptions to discuss responses, there has not been enough progress. Execution venues are decentralized and unable to agree on common rules. While an industry-based solution is preferable, some issues cannot be addressed by market forces alone and require a regulatory response. Innovation is critical to a healthy and competitive market structure, but not at the cost of introducing substantial risk.

Regulators and industry participants, including asset managers, broker-dealers, exchanges and trading firms, have all put forth ideas and reforms. We agree with a number of their concerns and propose the following four principles:

• First, the equity market needs a stronger safety net of controls to reduce the magnitude and frequency of disruptions. A fragmented trading landscape, increasingly sophisticated routing algorithms, constant software updates and an explosion in electronic-order instructions have made markets more susceptible to technology failures and their consequences.

We propose that all exchanges adopt a stringent set of uniform, SEC-mandated execution controls to reduce errors. In addition to limit-up, limit-down rules that prevent trades from occurring outside a specified price band, pre-trade price and volume limits should be implemented to block problematic orders from entering the market. Mechanisms should also be introduced to halt a firm's, market maker's or other entity's trading when an established threshold is breached, thus minimizing the uncontrolled accumulation of trades.

• Second: Create incentives to reduce excessive market instability. The economic model of the exchanges, as shaped by regulation, is oriented around market volume. Volume generates price discovery and liquidity, which are clearly beneficial. But the industry must recognize how certain activities related to volume can place stress on a market infrastructure ill-equipped to deal with it.

Electronic-order instructions connect the objectives of buyers and sellers to actions on exchanges. These transaction messages direct the placement, cancellation and correction of orders, and in recent years they have skyrocketed. In the 2010 "flash crash," a spike in the volume of these messages exacerbated volatility, overwhelming the market's infrastructure.

According to industry analysis, since 2005 the flow of these order instructions sent through U.S. stock exchanges has increased more than 1000%, yet trade volume has increased by only 50%. One consequence of the enormous growth in order-message traffic is that increasingly the quote that an investor sees isn't the price he or she can transact, as orders often get canceled at lightning-quick speeds.

Currently there is no cost to market participants who generate excessive order-message traffic. One idea would be to consider if regulatory fees applied on the basis of extreme message traffic—rather than executions alone—are appropriate and would enhance the underlying strength and resiliency of the system. Regulators in Canada and Australia have adopted this approach.

• Third: Public market data should be disseminated to all market participants simultaneously. Exchanges currently disseminate prices and transaction data to the SEC-sanctioned distributor for all investors, but exchanges may also send this information directly to private subscribers. While the data leave the exchange simultaneously, the public data are delayed because they go through the intermediary's processing infrastructure. The public aggregator should release information to all market participants at the same time.

Removing the possibility of differentiated channels for market data also reduces incentives that favor investment in the speed of one channel over the stability and resiliency of another. Instability creates and compounds market disruptions. Stable and accurate market data is one of the most important elements of market safety; it is the backbone of the market that must weather the most extreme periods.

• Fourth: Give clearing members more tools to limit risk. A central clearing house with strong operational and financial integrity can reduce credit risk, increase liquidity and enhance transparency through enforced margin requirements and verified and recorded trades. But because clearing members extend credit, the associated risks must be recognized. Tools like pre-trade credit checks and being able to monitor positions and credit on an intraday basis are essential. Clearing firms use various tools like margin and capital adequacy to manage their risk, but exchanges should also provide uniform mechanisms for clearers to set credit limits and to revoke a client's ability to trade immediately upon request, when necessary.

U.S. markets today are the deepest, most liquid in the world and serve an indispensable role in allocating capital. That means the companies that have the greatest potential to innovate and grow will get the capital they need to create jobs, build new industries and ensure a vibrant economy. Investors have benefited significantly from technology and innovation, but the speed and complexity at which our markets operate aren't being matched with the operational and control environment to support them.

Mr. Cohn is president and chief operating officer of Goldman Sachs

Shedding Some Light on Shadow Banking - Don't let a vaguely sinister label for this useful financing prompt harmful regulations

Shedding Some Light on Shadow Banking. By Tony James
Don't let a vaguely sinister label for this useful financing prompt harmful regulations.
WSJ, Mar 04, 2014
http://online.wsj.com/news/articles/SB10001424052702304255604579408991330843998

The term "shadow banking" is one of those Orwellian terms that can undermine critical thought. It has a negative, vaguely sinister connotation about a source of financing that is an essential and desirable part of the financial system. As discussion about the regulation of nonbank entities begins in earnest, it's time to clear the air about what these institutions are and how they operate.

Shadow banking—or more accurately, market-based financing—is simply the provision of capital by loans or investments to some companies by other companies that are not banks. Examples include insurance companies, credit investment funds, hedge funds, private-equity funds, and broker dealers. These institutions do not operate in the dark. Market-based finance in the U.S. amounts to trillions of dollars and is significantly larger than the country's entire banking system.

Mark Carney, Governor of the Bank of England, has correctly noted the role of shadow banking in "diversifying the sources of financing of our economies in a sustainable way." For example, traditional bank financing is not always available for many small- and medium-size companies. Market-based financing has fueled the creation of companies (and thousands of jobs) in many industries. It has rescued companies on the edge of bankruptcy and saved the jobs associated with them. And market-based financing has built warehouses, manufacturing plants and hotels, such as the Four Seasons Hotel and Residences in downtown New York City, when traditional banks could not, or would not, provide capital.

Large banks concentrate risk in relatively few hands, which can pose a risk to the economic system. That is not the case for market-based financing. Risks are safely dispersed across many sophisticated investors who can readily absorb any potential losses. Unlike traditional banks, market-based funds do not borrow from the Federal Reserve, nor do they rely on government-guaranteed deposits. Substantially all their capital comes from well-advised institutional investors who know what they are getting into, and understand the associated risks. Bank depositors (and taxpayers) on the other hand, do not typically know what a bank's investments are or how risky they may be.

Typically, market-based funds also lack the elements that are sources of systemic instability, including high leverage and interdependence. Each investment within a fund is independent and not cross-collateralized or supporting a common debt structure. Losses in any one fund are without recourse to any other fund or to the manager of the capital.

In addition, investors in many market-based funds, including credit investment funds, hedge funds and private-equity funds often cannot instantly withdraw their capital, unlike depositors in banks. Large, sudden withdrawals can lead to runs on the bank or force "fire sales" of assets. With stable, in-place capital, these funds can provide a critical source of liquidity to trading markets in times of turmoil.

Of course, some regulation may be appropriate for nonbank entities that present bank-like risks to financial stability or that lend to consumers. But let's not forget that it was the regulated entities that were the source of almost all the systemic risk in the financial crisis.

Regulations are far from a panacea and would need to be carefully constructed to ensure that the enormous economic benefits of market-based financing are not lost through inappropriate and stifling regulatory policies established for large, deposit-taking banks.

While banks in the U.S. are better capitalized and much safer today than before the financial crisis, market-based financing—shadow banking, if you prefer—still brings enormous economic advantages to a wide range of businesses and employees, and fills a real gap in the market.

In Europe, where banks are less well capitalized, the need for market-based financing is even more critical. As the G-20's Financial Stability Board noted in its policy framework last August, market-based financing creates "competition in financial markets that may lead to innovation, efficient credit allocation and cost reduction."

It is critical that any misunderstanding of the shadow banking system does not result in regulations that undermine the many thousands of companies and jobs that need market-based financing to survive and grow.

Mr. James is president and chief operating officer of Blackstone, a global investment and advisory firm.