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E-MailAndreas M. Fleckner is a Senior Research Fellow at the Max Planck Institute for Comparative and International Private Law in Hamburg. This post is based on a chapter prepared for The Oxford Handbook of Financial Regulation (forthcoming).
High-frequency trading, dark pools, front-running, phantom orders, short selling—the way securities are traded ranks high among today’s regulatory challenges. Thanks to a steady stream of news reports, investor complaints, and public investigations, it has become commonplace to call for the government to intervene and impose order. The regulation of trading practices, one of the oldest roots of securities law and still a regulatory mystery to many people, is suddenly the talk of the town.
From a historical and empirical perspective, however, many of the recent developments look less dramatic than some observers believe. This is the essence of Regulating Trading Practices, my chapter for the new Oxford Handbook of Financial Regulation. The chapter explains how today’s regulatory regime evolved, identifies the key rationale for governments to intervene, and analyzes the rules, regulators, and techniques of the world’s leading jurisdictions. My central argument is that governments should focus on the price formation process and ensure that it is purely market-driven. Local regulators and self-regulatory organizations will take care of the rest.
Market-Driven Price Formation as the Key Regulatory Objective
Why is the price formation process so critical? Because it removes uncertainty and strengthens confidence among investors. Whether orders are matched manually on a trading floor or automatically by an electronic trading system, whether in medieval Antwerp or on a fancy off-shore server: no buyer or seller in his right mind would place an order if price formation were arbitrary and opaque. Traders do not insist on knowing the execution price in advance. Only fraudsters and manipulators will. What traders do demand, though, is that price formation is shielded from abuse, swindle, and discrimination.
The chief principle reasonable traders would agree on in advance, besides transparency and fairness, is that the price formation process ought to be entirely market-driven. Nothing but supply and demand should dictate prices. The rationale for this principle is that over time, traders can expect to be buyers and sellers alike, to be up to date or uninformed, to hold larger or smaller positions, and so on. There is no point in systematically favoring either side.
Can traders trust the exchanges that price formation will be entirely market-driven? There is no clear answer because the exchanges’ historical record is mixed. In their efforts to standardize and facilitate trading, exchanges from the earliest days onward did, indeed, set rules that governed the process of trading and the procedure by which prices were determined. But even the greatest supporters of self-regulation will have to admit that exchanges often fell short of properly policing price formation—most recently with regard to some forms of high-frequency trading. Given the public’s outrage over price distortions and the exchanges’ mixed historical record in preventing them, it seems that self-regulation alone will currently fail to create the public trust in price formation that efficient markets call for. It follows, then, that governments should step in and shield price formation from deliberate or accidental distortion.
Allocation of Regulatory Powers
Strengthening public trust in the price formation process is a narrowly defined mandate, not a carte blanche for extending state intervention to trading practices that do not negatively affect price formation. This puts a question mark on many of the regimes currently in place.
Take the U.S. and Germany, two particularly notorious examples. They regulate trading through a rising glut of rules, norms, and standards, rely on a motley crew of regulators, supervisors, and self-regulatory organizations, and resort to a colorful bouquet of techniques, strategies, and methods. What they lack, though, is a proper leitmotif or thread running through their regulatory regimes. As a result, rules are too long and complex, regulatory powers are spread over too many agencies, and the various techniques employed are at odds with one another.
In contrast, if adequately anchored at the top of the regulatory hierarchy, the idea that prices should accurately reflect market supply and demand would help avoid the current shortcomings. Policymakers could follow a principles-based approach at higher regulatory levels, designate market-driven price formation as the key objective in the regulation of trading practices, and lay down the core rules and principles, including transparency and fairness. The fine points could be left to local regulators and self-regulatory organizations, depending on existing regulatory structures and philosophies.
While delegating the details to lower regulatory levels will help streamlining the overarching regime, regulation on-site rather than from afar also comes with a number of additional benefits, such as experience and technical expertise, proximity and promptness, acceptance and persuasive power, better resources, detachment from day-to-day politics, and innovation through regulatory competition. The regulation of trading practices is a prime candidate to reap those benefits because there are few areas where the information asymmetry between those on-site and those watching over the markets is greater. That self-regulation has failed many times is of course true. But so have regulators appointed by governments. In fact, there is no empirical data indicating that state regulation has fared any better than self-regulation. Nor are there accounts by historians suggesting that self-regulation in most cases meant no regulation, as critics sometimes claim. Instead, history reveals a wide spectrum of self-regulatory intensity.
Implications for Insider Trading, Algorithmic Trading, and Short Selling
Ever since the beginning of standardized trading, some of the techniques employed by traders have raised concerns among policymakers. As a result, many practices have been banned over the years, and there is nothing wrong with that—as long as the trading bans protect price formation from distortion and ensure that prices accurately reflect market supply and demand. Well-known examples include rules against “marking the close,” i.e., patterns that artificially inflate closing prices, or against “wash sales,” i.e., practices that misleadingly boost trading volumes. But other trading restrictions may well have adverse effects on price formation because they hold back orders that, if placed, would make prices more informative. Outlawing insider trading is the prime example. If the regulatory aim is to ensure that prices accurately reflect market supply and demand, then banning insider trading is counterproductive (there may be other good reasons though).
How about algorithmic trading and short selling, currently two of the most controversial topics among regulators? Do they threaten orderly price discovery? Should governments intervene and put additional restrictions on them?
Economic models suggest and empirical studies confirm that algorithmic trading has many benefits. High-frequency trading, for instance, helps prices adapt more quickly to changes in market supply and demand, making prices more informative and trading more efficient. The public debate, in contrast, has focused on those techniques and strategies that are believed to rig the markets, unleashing a storm of criticism. However, while some forms of algorithmic trading are certainly at odds with general principles of securities law, this is just a small aspect of a much broader phenomenon. At the heart of the debate lies a controversy about market design: what is the optimal level of automation, what is the optimal speed and frequency of trading? There are many other market design questions with a similar dimension, such as whether an exchange should have a manual trading floor or an automated trading system, whether trading should be concentrated in a few hours or span the entire day, whether continued trading or periodic auctions are preferable, and so on. Almost all of these questions are typically left to the local regulator or to those on-site. No evidence has been produced that would call for treating algorithmic trading differently.
A similar picture emerges for short selling, a technique that has been regulated on various levels for over four centuries. Nothing has happened that would require governments to impose additional restrictions, and empirical studies show the devastating effects of those restrictions that have been enacted nonetheless.
The full chapter is available for download here.
