The pivotal role exchange volatility control mechanisms can play during a market crisis came under the spotlight at FIA Expo at the beginning of October.
"Exchange volatility controls, when appropriately tailored, are really important for promoting market integrity and ensuring fair and orderly markets," Aaron Friedman, deputy US head of government and regulatory policy at Citadel Securities, said at the conference, which brought together more than 1,500 people involved with derivatives trading and clearing.
"What they are intended to do is address situations such as operational errors, technology issues, or temporary supply and demand imbalances, which result in disorderly trading," he said. "What they are not supposed to do is interfere with the market’s ability to reach a new equilibrium price, which could be significantly higher or significantly lower than the current market price."
The overarching aim of exchange volatility control mechanisms is to minimise disruption caused by a trigger event that causes short-term extreme price movement – such as a "fat finger" erroneous trade, large aggressive orders, or a flash crash – without impeding the ability of an instrument to reach a new equilibrium price level based on healthy market dynamics.
The panel discussion took place after FIA published a Best Practices for Exchange Volatility Control Mechanisms paper, developed in consultation with global derivatives exchanges and market participants. The paper explores the most effective ways for exchanges to mitigate disruptions while ensuring transparent price discovery and provides essential guidance to derivatives exchanges looking to design these mechanisms.
Speaking about the paper, Lyndon Freedman, director of e-trading risks at Bank of America, said he is hopeful that derivatives exchanges will start implementing volatility controls if they have not already.
"Some exchanges who were not involved in the paper wanted to know what was going on and we explained to them the 'too far, too fast' control, which is for erroneous trades mostly," Freedman said. "We are working with exchanges and FIA to get some of these exchanges that do not have those controls to implement them. There is an appetite for it; these exchanges want this paper to exist so they can say 'This is the prescription that all the larger exchanges have. If we want to be competitive, we need these controls as well".
Volatility control mechanisms include a range of tools, such as pre-trade limits on order prices, daily price limits, circuit breakers, and other ex-ante and ex-post controls that interrupt markets for a brief predetermined time interval to give participants time to react to new information and for the market to attract more liquidity.
Speaking about the overall philosophy behind volatility controls, John Scheerer, senior director of global operations at CME Group, pointed to the responsibility of exchanges to protect market integrity.
"We do not want to intervene in the market. We believe that the fair value of any market at any time should be decided between the buyers and the sellers, but there are a lot of things that can happen in electronic trading," he said.
"News is absorbed very quickly; you have a mixture of manual traders and automated traders, and sometimes customers make mistakes. We are responsible for protecting the integrity of the market, so customers have the confidence that when they come to trade on our platform, there are controls in place."
Trabue Bland, senior vice president of futures exchanges at Intercontinental Exchange, added that an exchange's job is to keep markets open and that trading interruptions should only be triggered sparingly.
"We do not want to step in front of a price formation – that is the worst thing an exchange can do. However, we do want to make sure that market participants are comfortable trading those markets and that we catch things in obvious areas," he said.
"Regulators want to see these volatility controls in our markets, and sometimes they go as far as to say that they would like to see them tripped, but sometimes that just doesn't happen" when market moves are significant but orderly, Bland said.
When designing volatility controls, Citadel's Friedman said exchanges must rigorously test and review the mechanisms, and ensure that information is readily available to market participants on how the controls operate and the thresholds that would result in the controls being triggered.
"These controls need to be tailored to the specific characteristics of a market and they need to be regularly and rigorously reviewed – all the parameters, the thresholds, and the triggers. It's not just a 'you create the rule, and then you get the data and do a quick check to make sure they're done'. It's really a robust process and as markets evolve, they need to continue to be fit for purpose," he said.
"It's also important that the rules surrounding volatility controls are clearly spelled out in exchange rulebooks so we, as market participants, can reasonably expect what's going to happen and can replicate calculations regarding triggers in advance so that we can prepare accordingly," Friedman said.
