Liquidity and the regulation of markets

Christian VoigtLast week’s TradeTech in London included a talk about liquidity by David Lawton, the FSA’s Acting Director, Markets, during which he discussed all the hot potatoes that MiFID II has to offer.  For a change, this was not another piece of 500 millisecond nonsense but included some sensible and well considered arguments. Here are the highlights of his key points:

•    Liquidity is not a binary concept – it is multi-dimensional and exists in a spectrum. We can’t, for example, directly compare the liquidity of a FTSE100 share with that of a mortgage-backed security or a commodity option. What we are after is transparent and resilient liquidity.
•    The response has been to contemplate putting limits and obligations on high-frequency trading (HFT) firms. It’s not clear whether policymakers have fully considered the possible impact on liquidity provision from such measures.
•    For example, the ban on OTF operators using their own capital, if adopted, has the risk of damaging liquidity in bond and derivative markets. The potential conflicts of interest when a firm is both an operator and a participant of a trading platform can be addressed by requiring OTF operators to apply rigorous conflict management processes, as is proposed for MTFs.
•    A second issue is whether firms deploying algorithmic trading should be subject to continuous market-making obligations. The FSA recognises that this proposal is motivated by a rational concern that, in times of crisis, algorithmic systems are likely to withdraw liquidity from the market. On the other hand, they need to consider the potential impact such market-making obligations might have on trading participants if the law prohibits them from stopping trading when they experience losses. It may be that, in times of market stress, firms will ignore the market-making obligations and withdraw from trading. Alternatively, firms may decide to pull out of trading certain instruments or strategies, and the knock-on effect may be a reduction in liquidity across markets.

For a full transcript of Mr Lawton’s speech click here.

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