The PRA has published a speech given by Andrew Bailey (Deputy Governor, Prudential Regulation and CEO, PRA) entitled Financial Markets: Identifying risks and appropriate responses.
At the beginning of his speech Mr Bailey remarks that the last two decades have seen major changes in the financial system. There has been a fundamental and rapid change in the microstructure of financial markets. Electronic platforms are increasingly used in a number of major financial markets. As part of that change, automated trading has become common in those markets. Within automated trading, there has been a growth in high frequency trading. While electronic trading has contributed to increasing market efficiency and probably reducing transaction costs, there are also risks that arise from trading strategies that are flawed, or where in constructing the strategy not all possible outcomes were considered, including the ability to trade large blocks.
Mr Bailey mentions that the PRA will continue to develop its capacity to assess algorithmic or automated trading, including the governance and controls around the introduction and maintenance of trading algorithms, and the potential system-wide impact of crowded positions and market liquidity. The PRA will assess the adequacy of existing risk measurement and management practices in capturing exposures from the large volume of intraday trading instigated by these algorithms. Mr Bailey states that the PRA will also continue to develop its assessment of whether trading controls deployed around algorithmic trading are fit for purpose, and in doing so it will capture insights on the role of market making on electronic platforms. This is all part of the PRA’s task of supervising firms’ trading books. Mr Bailey adds that this should be assisted by the introduction of MiFID II in Europe, which will impose rules on algorithms and high frequency trading, including the introduction of circuit breakers, minimum tick sizes and maximum order-to-trade ratios, which will improve market stability.
At the end of his speech Mr Bailey summarises six areas where action is already underway to reduce impediments to the development of diverse and sustainable market based finance. These are:
- in this year’s Bank of England (BoE) concurrent stress test, substantial steps are being taken to enhance the coverage of market risks. The new approach to stress testing trading activities will capture how fast banks could unwind or hedge their trading positions in the stress scenario;
- the BoE, working with the FCA and HM Treasury have set up the Fair and Effective Markets Review to restore trust and confidence in the fixed income, currency and commodity markets. The review will publish its recommendations in June. Mr Bailey believes that out of this assessment, and based on the consultations so far, there will come priorities on market structure “standards” and transparency, effective competition, professional culture within firms and effective, pre-emptive supervision which reduces the drama of ex-post enforcement;
- initiatives to improve the functioning of markets to support activity in real economies. Mr Bailey mentions that the aim behind the European Commission initiative on Capital Markets Union is to strengthen markets in the EU to support growth and stability. Likewise, sound securitisation is a goal of the wider financial reform programme;
- activities around so-called securities financing transactions (SFTs) including securities lending and repurchase (repo) agreements. The Financial Stability Board has taken steps to introduce haircuts on SFTs that are not centrally cleared, with the aim of preventing excessive leverage becoming available to shadow banks in a boom, thereby reducing the procycliality of that leverage;
- initiatives relating to the risk of asset managers offering short-term redemptions to investors against potentially illiquid securities. In 2012 the International Organization of Securities Commissions issued recommendations that provide a basis for Common Standards for Money Market Funds across jurisdictions, in particular seeking to ensure that money market funds are not susceptible to the risk of runs. More broadly, Mr Bailey mentions that work continues on putting into practice appropriate policies and standards to prevent the risk of disorderly sales of assets in the face of investor withdrawals; and
- central banks can back-stop market liquidity by acting as market makers of the last resort. Mr Bailey states that the BoE has described in its so-called Red Book how it could act in such a way in exceptional circumstances.
View Financial Markets: Identifying risks and appropriate responses, 15 May 2015