Flash Freezes and Dark Pools: A Focus on US Capital Markets

The US market has been on an uneven road to recovery in the
past few months. Recent industrial production figures indicate that a recovery
might be afoot, but this contrasts with the decline in American consumer
confidence, which could impact spending in the near future. However, the US
economy did manage a growth rate of 2.5% in the second quarter of 2013, up from
a 1.1% rate in the first three months of the year.

In keeping with the
improved state of the US economy and the lower need for economic stimulus from
the government, the Federal Reserve is expected to announce measures to reduce
its quantitative easing (QE) programme, even though it announced on 18 September
that its bond buying programme would continue for now. While some agree with
this development, many observers believe that some areas of the economy, such as
retail spending and unemployment, might struggle to recover if QE is slowed

In the capital markets, we have seen lower volumes and lower
volatility than in the recent past. An important recent development in the
financial markets is a focus on the need to improve the reliability of US
exchanges. Several episodes over the past couple of months have highlighted the
magnitude of the task facing the regulators and exchange operators alike. In one
instance, a large number of erroneous trades hit US equity options markets on 20
August as they opened for business, when Goldman Sachs sent orders accidentally
because of a technical error. The trades impacted markets and underlined the
uncertainty caused in financial markets by such technological problems. In
Nasdaq’s three-hour-long shutdown on 22 August, termed the ‘flash freeze’, a
coordination failure played havoc.

To give a brief background to the
episode, all stocks in the US markets are listed on either the New York Stock
Exchange (NYSE) or Nasdaq. However, there are 13 different exchanges that
process trades for these stocks. In order to ensure that traders dealing in a
stock get the best possible price, both the NYSE and Nasdaq use a Securities
Information Processor (SIP), which basically is a system that brings together
quotes for the stock from all the exchanges and publishes a continuous ‘national
best bid and offer price’ (NBBO) at which trades for that stock can be executed.
There can be issues if the communication between exchanges and the SIPs breaks
down and this is what exactly happened. An exchange operated by the NYSE lost
touch with Nasdaq’s SIP, and a glitch in Nasdaq’s software exacerbated the
problem. This issue was followed by a similar problem with a smaller exchange
called the Chicago Board Options Exchange (CBOE), just days ago on 13 September.

In light of the Nasdaq issue, on 12 September, the US Securities and
Exchange Commission (SEC) chair Mary White met with the senior executives of the
major exchanges, and announced reforms to address such problems. US stock
exchanges agreed to implement changes in how they would respond to similar
disruptions in the future. The reforms include the possible use of a ‘kill
switch’ that would enable an exchange to stop trading during emergencies. The
exchanges would have to draft action plans to establish testing and disclosure
protocols related to systems changes for their securities information
processors. They also are required to provide a plan to address how regulatory
halts are communicated to participants, assess their other critical
infrastructure systems and review their current rules for nullifying erroneous
trades and re-opening trading after a stoppage.

Dark Pools Obscure

Another important capital market issue that has been doing the
rounds is that of the increasing role played by so-called ‘dark pools’, or
institutional orders unavailable to the general public. At present, it is
believed that between a quarter to a third of all cash equities trading in the
US occurs at dark pools, which do not disseminate their prices publicly. Hence
the dark pools are alleged to lead to a lack of transparency and higher

The large number of trading platforms – including around sixty
dark pools – also leads to a high level of fragmentation, which increases the
cost of trading for market participants. Dark pools also make it tough for
retail investors to participate in a market that seems to be much more suited
for institutional participants. For these reasons, besides self-interest, the
leading US exchanges have been pressuring the SEC to pass a ‘trade-at’ rule.
This would require brokers to route an order to an exchange unless they can
improve on the best public quote by a defined amount on a trading platform such
as a dark pool. The example that has been referred to is that of Canada, where
the imposition of such a rule last year is believed to have led to falling
quoted spreads and volatility. While the direct impact of the ‘trade-at’ rule
would be to drive liquidity towards exchanges and away from dark pools,
indirectly they could lead to consolidation in the dark pool market as a number
of platforms have been struggling with falling profitability and uneven
performance recently.

The need for consolidation is not just restricted to
the dark pool market, with
BATS Exchange and Direct Edge Exchange

announcing on 26 August that they planned to merge, with the transaction
expected to be completed by the first half of 2014. The main spur for this
development has been the four-year decline in volumes, which has made it tougher
for exchanges to survive. The merged entity would be second-largest in the US
market. Furthermore, falling volumes and the trend for consolidation is
beginning to affect prop trading firms and high frequency traders as well. There
has been a 36% decline in the US equity market volume since 2009, which has in
turn meant that profits of high frequency trading firms have declined by as much
as 80%, meaning mergers and closures are inevitable if conditions do not

Moving away from the equity markets, an important upcoming
development is the October 2013 deadline for swap execution facilities (SEFs),
which are to become the main over-the-counter (OTC) derivatives trading
platforms in the US. According to some estimates, by 2014 as much as 70% of OTC
derivatives volumes could be traded on SEFs, in addition to central counterparty
clearing (CCC). The idea is to reduce counterparty risk and create markets that
are more transparent, efficient and accountable. It is believed that the US
example could be followed in the leading OTC derivatives markets around the
world if it becomes successful, as opposed to the current situation where most
non-US markets prefer to have CCC for OTC derivatives, without necessarily also
going for multi-party trading platforms.

Hence, while there are some signs
that the US economy is recovering, it has been a difficult year for some
constituents of the capital markets, with further changes afoot that would
continue to change the market dynamics. We are in for a rollercoaster ride in
the coming few months, as cash and derivatives markets both continue their
attempts to modernise and deal with the various risk and technology issues that
have arisen in the fallout from the 2008 financial crisis.


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