The electronification of financial markets, with trading increasingly carried out via electronic platforms and algorithms, poses significant regulatory challenges. On one hand, technologically driven market innovations can reduce transaction costs, improve liquidity, and expand access to investments. However, they can also enable abusive behaviors like aggressive high frequency trading strategies, introduce new systemic risks, exacerbate market volatility, and undermine transparency.
Ensuring regulatory balance
Striking an appropriate regulatory balance is crucial but difficult in this environment of rapid change. Overly lax rules risk eroding market integrity and stability, harming investors, and diminishing public trust. Yet excessive regulation may stifle beneficial innovation, drive trading off-exchange, reduce competitiveness, and impose undue compliance burdens. How can regulators keep markets safe and fair while still promoting efficiency and technological progress?
Regulatory issues
Several core regulatory issues have emerged around market electronification, each requiring careful navigation between valid competing interests. These include appropriate oversight of new electronic trading venues, effective monitoring of automated trading activities, ensuring robust exchange cybersecurity measures, updating circuit breaker rules to account for electronic speed and interconnectedness, implementing appropriate registration and testing for algo trading systems, requiring meaningful market data disclosures, and enforcing development and compliance with best practice standards by exchanges and electronic traders.
The rise of electronic trading systems
New electronic trading systems allow much greater fragmentation of liquidity and trading activity across numerous competing venues, reducing transparency. Light touch regulation of these new platforms, like the initial regulatory approach to “dark pools,” risks abusive activities flourishing out of sight. However, imposing overburdening regulatory requirements may simply incentivize further shift of trading off regulated exchanges. Finding the right touchpoint, adapted over time, is key to balancing innovation against integrity and stability. Expanding the consolidated audit trail and enhancing cross-market oversight mechanisms can increase insight while avoiding restrictive mandates on emerging competitors.
Automated and algorithmic trading now account for over half of all U.S. equity market volume. While offering many potential efficiencies, their sheer speed and complexity also amplify risks. Insufficient safeguards around algo-trading can lead to damaging episodes like the 2010 Flash Crash. Well-designed registration, testing, and monitoring regimes are needed to reduce harmful coding errors and exploitatively manipulative programs. But forcing disclosure of closely guarded proprietary strategies may undermine innovators’ competitive edge. Evolving programs like FINRA’s CAT and the SEC’s Reg SCI point towards workable balances between accountability and permissionless innovation.
The impact of cloud migration
As trading infrastructure moves to the cloud, strengthening cyber defenses is crucial to avoiding catastrophic data breaches or system outages. Though exchanges face extensive vulnerability testing requirements under Reg SCI, some critics argue for expanded standards and auditing. However, ratcheting up mandates too far could prove very onerous for smaller trading venues. Encouraging industry-led initiatives around resilience and security, like the SIFMA-led Sheltered Harbor program, may constructively supplement governmental oversight while allowing flexibility.
The increase of trading speed
The hyper-speed of electronic trading necessitates updating old market safeguards so they can still serve their function. Legacy circuit breakers halt trading based on percentage declines over the course of a day – yet markets can now crash much faster than that. Redesigned breakers, like Limit Up/Limit Down bands that pause trading when prices move too far too fast, are tailored to modern electronic environments. Moving towards exchange-neutral controls and bolstering cross-market coordination would further strengthen protections.
Managing the Rise of Automated Investment Advisers
Another major regulatory challenge involves overseeing the rapid growth of “robo-advisers” – algorithm-based investment management services providing automated portfolio recommendations and trade execution with minimal human intervention. As assets under robo-management swell into the hundreds of billions, key questions arise around ensuring sound fiduciary standards, transparency, and accountability.
On the one hand, robo-advisory services can expand access and lower costs for many less affluent investors previously underserved by human investment managers. They also tend to use passive, diversified strategies tied to a client’s customized risk tolerance – a simpler yet sounder approach for unsophisticated investors. However tight regulatory oversight is still warranted given the heightened vulnerabilities automated services create around everything from coding errors to conflicts of interest, to outright fraud.
While robos should enhance advice transparency and fealty to client interests, they also involve very limited human interaction and judgment. Requiring clear explanations around algorithms, underlying data, and product selection criteria is crucial so customers understand what drives portfolio decisions. Stronger disclosure and due diligence rules around robo-advisers, like those put forward by the SEC and state regulators, aim to shed light on potential biases while establishing higher standards of care. Updating custody and audit processes to cover automated platforms also helps ensure client assets are properly tracked and protected.
Addressing New Systemic Risk Transmission Channels
The increasing electronification of trading also necessitates rethinking systemic risk regulation. New electronic linkages between markets introduce fresh financial stability transmission channels not captured by existing oversight frameworks.
For one, automated arbitrage strategies now tightly bind markets across borders and assets in new ways. A disruption in one domain can thus swiftly carry through algorithmic traders to other exchanges. Yet systemic risk monitoring remains largely siloed along jurisdictional and asset class lines. Enhancing cross-market monitoring and international regulatory coordination is crucial to spotting dangerous build-ups across this new electronic web of interconnectedness.
Relatedly, trading infrastructure like data feeds, cloud computing, and exchange matching engines are now highly concentrated across a handful of providers. Outages at key hubs like Amazon’s cloud or critical data vendors could cascade across markets with severe systemic repercussions. Regulatory oversight however remains narrowly focused on individual trading venues rather than these market-spanning backbone services. Expanding resilience expectations and stress-testing mandates to include critical market utilities could address this gap.
Final words
Overall, regulators continue struggling to adapt old rules to rapidly evolving electronic market structures. While operationalizing core principles of transparency, stability, fairness, and integrity, they must be careful not to hinder technological progress or over-centralize control. Beyond formal rulemaking, facilitating industry collaboration around best practices and principles-based self-regulation may prove an agile path to help markets safely harness new technologies. The optimal path forward remains fiercely debated – but continuing open-minded experimentation towards the right calibrations is key.
