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FEDERATION OF EURO-ASIAN STOCK EXCHANGES ANNUAL REPORT APRIL 2011 NASDAQ OMX Market fragmentation poses serious challenges to the surveillance function. Lorne Chambers Head of Sales and Account Management for SMARTS at NASDAQ OMX The challenges of cross-market surveillance Market fragmentation poses serious challenges to the surveillance function. A major concern is that the effectiveness of a single market’s surveillance efforts is reduced if it doesn’t incorporate trading data from all venues into its surveillance system.The natural consequence is that effective surveillance becomes more costly and there is a doubling of efforts across venues. In more markets, we’re seeing a single entity, such as a regulator, taking on the responsibility for consolidated market surveillance. Ideally, the price, volume and time of trades from all venues should be consolidated and made available to all participants. In the U.S., equity trades must be reported to a consolidated tape within a specified period of time. Trading venues populate their surveillance system with National Best Bid and Offer changes and prices from other venues, providing a view of trade-to-trade price changes across venues, but even that is not foolproof. While the current U.S. consolidated tape enhances transparency, it only identifies the trade's price, volume and time. It doesn't identify the broker that did it and whether it was done as a proprietary trade or on behalf of a client. As a consequence, you can’t link related trades across markets. Real-time data provided by data aggregators is also used to benchmark executions and make comparisons for surveillance purposes. However, some market participants find these products too expensive. Meanwhile, Europe is one step behind the U.S. The regulators have established a pan-European trade reporting system, but the data is unreliable because the member states do not follow the same protocols and standards, and it is an end-of-day system, not real time. Better cooperation is needed. Surveillance departments at exchanges and other trading venues need to be able to share sensitive information in a secure manner. The shared information would only be used for surveillance purposes, not for commercial purposes. Given the complexity of this operation, it will make sense for some trading venues to outsource it to an entity that has the expertise and advanced technology to handle it. In the meantime, this environment has made it easier for certain types of market manipulation to go undetected (see accompanying box). Operational issues can also undermine multimarket surveillance efforts. Market operators often respond to high volatility in a single security by calling a trading halt in that stock and issuing a price query to the listed company. This enables market participants to assimilate newly disclosed information and allows price discovery to occur through a call auction. Sometimes, alternative markets ignore the halt and continue trading, allowing participants with unfair access to information to trade before the primary market re-opens. Conclusion It is clear that market fragmentation has reduced the effectiveness of traditional single market surveillance. Each market can adapt and import a consolidated view of trading, identify unusual activity in their data and compare this to the consolidated data, but this approach is incomplete. Canada and Australia have adopted complete solutions where a single regulator has a fully consolidated, broker identified, order book of every security trading under its jurisdiction. Self-regulated organizations in the U.S. have strong surveillance capabilities but still require consolidated data. European markets recognize the need for consolidated data but face the added complexity of cross-border cooperation. Fragmentation is not yet a major issue in Asia and South America, but we expect it to be in the future. Surveillance challenges of market fragmentation • Unusual Price Changes: In fragmented markets, price changes need to be considered at the consolidated level. The solution employed in the U.S. is for every trading venue to populate their surveillance system with the national best bid and offer change as well as prices from other venues. This allows an accurate view of trade-to-trade price changes across venues, but does not identify the broker behind a more gradual price increase in a particular security when a broker’s trades are spread across venues. This can only be effectively accomplished by an entity with a complete market picture, such as a regulator, since exchanges are unlikely to allow their competitors to view which brokers are most active on their markets. • Unusual Volume Changes: Monitoring security volumes to identify potential disclosure issues is more difficult in fragmented markets. An increase in volume on one venue may be offset by a decrease on another. Only aggregate volume changes matter, so either the venues must import other venues’ trades or a single entity needs to monitor the consolidated volumes for the venues. PAGE 18
FEDERATION OF EURO-ASIAN STOCK EXCHANGES ANNUAL REPORT APRIL 2011 Types of market manipulation • Front Running: The practice of a broker trading ahead of an order for a client positions the broker to benefit from the price movement caused by the client order. In a fragmented market a broker’s order can be executed on one trading venue and the client’s order executed on another, making it impossible to see the connection at the exchange level. Considered in isolation, there is nothing wrong with these trades. Effective surveillance must be carried out by a team with access to the consolidated, broker identified, principal agency tagged trading data across venues. • Bait and Switch: In this scenario a market participant tries to achieve a better price by convincing other investors that there is a large aggressive buyer (seller) active in a company, when in fact the same investor is actually selling (buying). In a multiple venue setting, the two parts of the manipulative strategy can be split across two venues. For example, the large buying bait order may be placed on the market that has the most liquidity and the least risk of execution, while the owner of the bait order is selling the same security on another venue. Isolated surveillance is blind to this activity. • Dark Pool Gaming: Dark pools don’t provide any pre-trade transparency so investors don’t know the best bid or offer (BBO). In the U.S. and Europe dark pools are restricted to executing trades within or at the consolidated or primary listing BBO. Dark pools can be gamed by placing orders onto the lit books that narrow or move the reference BBO. Buyers who want to trade in the dark may place sell orders onto the primary market to reduce the reference sell price. Those orders need only be for a small number of shares, enough to register as the best BBO, making this a low cost strategy to significantly change the overall trade value of a large block in the dark. We have advised customers to deploy alerts that look for small trades in the dark, which test for liquidity, followed by a change in the spread on the lit book and then a large trade on the dark book. This pattern may indicate that a broker is moving prices on the lit book to improve its executions on the dark book. To identify this, the dark pool needs to have knowledge of the lit book BBO. • Taking Advantage of Market Open Differences: This type of market manipulation takes advantage of the same security trading on markets with different open times and where the closed market is primary. A large order is placed into the opening auction on the primary market, which although closed can still signal to the open markets that a price adjustment is necessary. Theoretically, a trader wanting to sell at a high price could place a large buy order at a very high price into the pre-open on the primary market and hope that the open markets’ prices react. There is no risk of the buy order being executed since it was placed on a closed market. To spot this activity, the non-primary markets will need to have the indicative opening prices on the primary markets fed into their surveillance system. Alternatively, the regulatory agent would need to have full order book surveillance of all markets. • Trading halts: Market operators commonly respond to high volatility in a single security by halting trading in a stock and issuing a price query to the listed company. This allows the market participants to assimilate any newly disclosed information and allows price discovery to occur through a call auction. In some cases alternative markets ignore the halt and continue trading, allowing participants with unfair access to information to trade before the primary market re-opens. Regulators need to ensure that a uniform process is followed by all trading venues based on a clear halting framework. CONTACT INFORMATION Contact Name Mr. Henri Bergström E-mail henri.bergstrom@nasdaqomx.com Website www.nasdaqomx.com PAGE 19
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