Banks and non-bank market-makers have begun discussing a draft protocol to encourage trading to transition onto alternative venues if a primary exchange crashes, according to three sources, with two having direct knowledge of the talks.

The talks are understood to be in an early phase and are being facilitated through two industry associations: the Association for Financial Markets in Europe (Afme) and the Futures Industry Association’s European Principal Traders Association (FIA Epta). Both associations declined to comment on the discussions.

“What we are discussing with Afme is an industry protocol that, if an outage happens, we do think that we will all be there and we all agree to be there,” says a regulatory source at a proprietary trading firm. “It doesn’t have to be binding, just a gentlemen’s agreement, where you say: ‘ok, we are going to continue trading in this manner,’ and therefore everyone will adhere to that.”

The protocol being considered would see adherents agree to funnel trading onto alternative venues—such as Cboe Europe and Aquis Exchange. It is hoped this will help solve widespread reluctance among market participants to act alone during an exchange outage.

On April 14 and July 1, 2020, Deutsche Börse suffered outages that put its stocking trading venue, Xetra, offline. Later in the year on October 19, Euronext shut down for three hours, with the closing auction failing at the end of the day. In all circumstances, trading largely halted in shares listed on those exchanges, even though the same instruments trade on alternative venues.

It is hoped that the Afme/Epta initiative will break a vicious cycle that disincentivizes everyone from trading. Two sources describe this as a “chicken and egg” problem.

“What has been the core problem in Europe and why we haven’t seen trading move during an outage to date is that there has always been this talk about: what is the reference price and what is the risk if we put our flow on alternative venues?” says Graham Dick, chief executive of Aquis Exchange Europe. “All these questions keep coming up and nobody makes the first step to actively put liquidity onto alternative venues when there is a primary market outage—that should absolutely happen.”

In the know

For market-makers streaming prices on venues, the probability of executing at unfavorable prices skyrockets during an outage, according to the regulatory source at the proprietary trading firm. They put this down to an increase in “informed flow” and a decrease in “uninformed flow”.

Uninformed flow is largely institutional flow from participants who want to obtain a particular security and don’t know where prices will move immediately afterwards.

Informed flow comes from investors with access to exclusive information that will move the price of a security in the very near future—for example, having faster news feeds, or being able to use pricing information sourced from different exchanges faster than other participants. This allows them to execute on quotes they believe are mispriced.

“If it is informed flow, as a market-maker you don’t want to make those trades,” says the regulatory expert at the proprietary trading firm. “Normally that’s fine, it happens, but you want the ratio of those trades to be low relative to normal trades, otherwise your profit expectation is negative and your risk is quite high.”

Since the flow of uninformed orders largely ceases during an outage, the proportion of informed flow increases, creating a disincentive for market-makers to offer tight bid-offer spreads—or indeed, to quote prices at all. This also means there is a first-mover disadvantage, because the brave or foolhardy market-maker that displays quotes with a tight bid-offer spread will be the only target for informed flow.

The agreement needs to involve the buy side, who currently shut up shop as soon as an outage occurs

Niki Beattie, Market Structure Partners

“If you are putting out quotes as a market-maker, you are at risk with those quotes at all times, but you don’t expect to do any trades apart from with somebody who is very informed, so your adverse selection skyrockets, then there is no real point in quoting,” says the regulatory source at the proprietary trading firm.

Meanwhile, brokers stop funneling trades to alternative venues because market-maker bid-offer spreads widen so much. With widening spreads, it is better for brokers to advise clients to wait until the outage has been resolved before trading.

By coming to a gentlemen’s agreement, the hope is that both sides will be comfortable transitioning activity onto alternative venues. Market-makers will quote tighter bid-offer spreads and take more risk on the alternative venues, while brokers will be able to advise clients that the conditions are good for trading.

“There will be liquidity, there will be trading. As soon as it is there, the folks who are skeptical will join in,” says the regulatory source at the prop trading firm.

Niki Beattie, chief executive of advisory firm Market Structure Partners, says the protocol designers should consider bringing in the buy side as well, to increase the number of players creating orders during an outage. Asset managers also stop trading usually, partly due to unfavorable quotes being offered on the market.

“Those with the natural liquidity have to be in play, as they are the ones who really form the prices and then the market-makers respond,” says Beattie. “The agreement therefore needs to involve the buy side, who currently shut up shop as soon as an outage occurs.”

More than words

Most sources agree that the protocol alone won’t be enough to guarantee continuous trading. Other actors in the market have recently published their own proposals for a protocol to resolve these issues, including a joint paper published by Cboe Europe and Aquis Exchange.

“It definitely helps a great deal, but I don’t think it is enough,” says Natan Tiefenbrun, head of European equities at Cboe Europe. “To ensure participants and end-investors have the certainty [about their positions] and the confidence to continue trading, venues must improve their process and communications during, and when recovering from, an outage.”

Other sources agree that improvements in the way exchanges communicate to the market during a failure are critical if continuous trading is to become a reality.

“What we don’t get is clear information around the status of our orders,” says Ben Springett, head of European electronic and program trading at Jefferies. “We aren’t being told about the technical status of the venue, and when we can expect some sort of resolution.”

As a result, participants are left uncertain about whether recent trades have executed. Two sources suggest exchanges should implement kill switches that reject all outstanding orders and stop accepting new orders in the event of an outage. The exchanges must then tell participants what orders have been declined so they know what positions they have/

“Participants need certainty about their risk and positions, and venues should have a clear set of procedures to deliver that certainty quickly,” says Tiefenbrun of Cboe Europe. “In the event of an outage, exchanges should cancel open orders, cease accepting new orders, and communicate a last known good trade time, with any subsequent executions being deemed invalid.”

Tiefenbrun adds exchanges need to ensure either they don’t publish stale market data based on orders they receive during the outage, or they warn the market that the data they are publishing is incorrect. This would avoid confusion among market participants on what sources of data they should use to determine reference prices, which inform the price at which a participant is willing to buy or sell a security.

Risk.net , a sibling publication of WatersTechnology, understands from an advisory source to primary exchanges that European exchanges are now looking at creating their own protocol to handle the process of improving the communication to the market around an exchange failure.

Participants are also debating whether an auction is needed to kick-start trading once a primary exchange shuts down. In theory, the industry protocol should mean trading seamlessly moves across and continues on alternative venues. But reality might play out differently.

“Ideally, we shouldn’t need a restart auction if we have an effective ability, as an industry, not to rely on the primary exchanges and therefore not to have a gap in trading,” says Springett. “The reality is that in any sort of outage… market participants will be the first to notice as they start to get rejections or pending orders, [whereas] the exchange in question won’t know what’s happening immediately because computers see it before humans do.”

While participants are waiting for the exchange to confirm the shut-down, activity will be limited, says Springett, and this could make a restart auction “a sensible option”.