Futures exchanges, already weathering depressed volumes, look set to see further drains on liquidity as proprietary trading shops steer clear of certain futures markets as a result of a Dodd-Frank driven crackdown on market-disruptive trading practices.
Rule 575 of the CME Group’s regulatory overhaul defines ‘bona fide’ trading activity and provides examples of the types of alleged disruptive trading practices – such as spoofing, quote stuffing, and banging the close – that it aims to stamp out. The rule will hit the market on September 15 and comes one year after the CFTC provided a similar clarification, but many feel it extends beyond the regulator’s own scope.
“CME’s Rule 575 is likely to have a chilling effect on volumes because people are going to be very concerned about the breadth of the rule,” said Paul Pantano, partner at Cadwalader Wickersham & Taft.
“Firms are going to want to avoid problems and so may even hold off on executing the legitimate strategies they have drawn up – the exchange says this just further codifies the prohibition of practices that were already forbidden, but I think this is broader than the existing rules.”
Despite the extended scope, Pantano and others expressed support for the rule, but it comes at a time when the exchange can little afford to push traders away.
Proprietary trading shops have long been some of CME’s biggest customers, bringing in chunks of volume as they trade in and out in small increments throughout the day. Exchange executives recently noted high-frequency trading represents 35% of group volume.
But low volatility has led to reduced trading volumes across the board. Average daily volume for the first half across all CME products slid by 12% year-on-year, leading to a 10% drop in revenue. The firm has tried to counter the drop by raising transaction fees and introducing a host of incentive programmes to entice new market participants and liquidity providers.
Given the business risks, CME has surprised some with its firm stance.
“What surprise[s] us is the candour with which CME describes such bad behaviour; we are not accustomed to that straight talk coming from stock exchanges,” noted Joe Saluzzi, head of Themis Trading and vocal opponent of HFT practices in equity markets, in a written statement.
Market participants particularly noted that the exchange uses specific examples of spoofing, quote stuffing, and banging the close – something others have been reluctant to do.
“Frankly, the rule reads much more plainly than similar rules in equity markets,” wrote Saluzzi.
Such disruptive activity has been an alleged staple of equity markets for years, but has only become a sticking point in futures markets relatively recently, with the CFTC in June intimating an intention to re-shape enforcement (see ”Automated trading rules approach futures markets”, IFR 2036 p76).
Enforcement
Enforcement against such activity has generally been a problem for regulators, because it is very difficult to prove market participants intended to mislead the market. High-frequency trading firms maintain they should be allowed to change their minds after putting in bids, not simply follow through blindly with every order.
The exchange said this week it plans to use circumstantial evidence to prove intent – a tough stance that is part of the reason prop shops are expected to step back from markets.
The rule will also be applied to non-actionable orders such as requests-for-quote, an aspect Pantano argues is broader than the CFTC’s rules.
If the rule does spur a decrease in activity, say some, it will simply be a by-product of a long-needed rule change.
“If 25% of volume was coming from wash trading [for example] and next week we see a 25% drop in volumes, then so be it – that’s ultimately a positive for the market,” said Eric Scott Hunsader, CEO of Nanex, a market data and technology provider that monitors for disruptive activity and has lobbied for the current changes.
“I do think in the long run this increases volumes as it increases confidence in the market structure.”