Rogue Algos, Splash Crashes and More Regulation in 2012?

2011 was a turbulent year for capital markets, with market volatility, rogue traders and high frequency trading (HFT) hitting the headlines. It looks like 2012 might follow suit, which makes it more important than ever to have a full awareness of your business.

We’ve been looking into our crystal ball to try and identify some of the leading issues likely to shape the capital markets industry in 2012. Perhaps unsurprisingly, considering the economic climate, lack of adequate risk management and public resentment against financial markets, we’ve predicted another tough year for those operating in this sector.

Looking back to this time last year, our 2011 predictions proved perspicacious; HFT and algorithmic trading blossomed in Brazil, China and India, algorithms grew smarter and some even began to self-learn. And banks shed proprietary trading desks, which sprang up as new firms or hedge funds elsewhere, in anticipation of the Volcker Rule. So what exactly does 2012 have in store?

Although financial institutions have tightened risk processes to prevent human fraud, particularly after the UBS scandal last year, they are still not adequately monitoring their algorithmic trading. All it takes is one rogue algorithm to go into an infinite loop, locked into continuously performing the same action, and the results could be disastrous, so perhaps this is something we might see.

We might also see the public, government and regulators starting the ‘Occupy HFT’ movement, mimicking the popular uprising against the ultimate elite of those making money in this climate. Despite immense financial industry pressure, over-zealous regulations will handicap high frequency trading going forward with draconian rules and controls. Because financial services firms are not proactive in managing risk and preventing issues such as fat finger errors and flash crashes, regulators will go too far and try to strangle HFT.

We have already issued a warning about over-the-counter derivatives trading, predicting that swaps execution facilities (SEFs) will enable them to be traded electronically. This, in turn, will lead to increased risk of a cross-asset class swaps ‘splash crash’ which will confound regulators, who have little understanding of these markets.

Global regulation will be a feature of this year, with countries finally realising that regulatory harmonisation is a good thing and that individual self-interest is not. Banks and financial services firms will realise that they need to think like regulators, taking control of internal surveillance and compliance before regulators make them do it.

We also predict that the West’s supremacy in financial markets will further decline as new trading regulations such as the Volcker Rule in the US and Markets in Financial Instruments Directive (MiFID) in Europe, create a surge of regulatory arbitrage favouring more lightly regulated geographies such as Russia and China. Wall Street and the City of London will lose human and financial capital as a result.

Despite western marketplaces finding it hard under new regulation, emerging markets stand to gain the most. The RICs in BRICs are getting smart order routing and gearing up for an increase in algorithmic trading. This, coupled with looser regulations, will begin to attract regulatory arbitrageurs and Volcker Rule escapees.

Another possibility is an increase in financial terrorism, with an exchange or trading destination hacked with the intent on manipulating markets for political gain. This will lead exchanges and ECNs to add more stringent monitoring and surveillance capabilities.

2012 will bring explosive growth in foreign exchange (FX) trading and SEFs. Even the smallest FX broker needs aggregation and pricing services, which require a big technology footprint. This need will drive new complex hosted FX solutions. SEFs will present new challenges as swaps markets attract algorithms and require surveillance.

Finally, regulators are cracking down hard on financial fraud and market manipulation and they will bring in some big fish in 2012. Prosecutions and punishments will increase in size and in impact as a result.

Although there are more fraud shocks to come, the good news is that financial firms and regulators are taking regulatory harmonisation seriously. One day soon we will have a global set of rules that mandate surveillance and monitoring, thereby proactively preventing fraud and flash crashes.

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