Market Matters | Rules and regulations

The London Stock Exchange has in the past issued a number of Compliance Updates. These took the form of newsletters containing brief, specific articles/commentary intended to assist compliance officers and other personnel who have responsibility for their member firm’s compliance with the Rules of the London Stock Exchange. Announcements about the publication of new Compliance Updates were emailed to individuals who had registered to receive such notifications via the Exchange’s website.

In June 2016, the Exchange replaced ‘Compliance Update’ with ‘Market Matters’, moving from a newsletter to the online publication of individual articles on a dedicated webpage. Market Matters articles do not constitute formal exchange guidance; this is communicated via Stock Exchange Notices and/or incorporated within the rules. Market Matters articles are intended to give examples of the kind of behaviour the Exchange is focusing on from a regulatory perspective; outline the lessons to be learned from market events or from Exchange disciplinary action; and provide commentary on various aspects of compliance with Exchange rules and related matters.

Member firms with queries regarding Market Matters should contact Market Supervision Enquiries: MarketSupervisionEnquiries@lseg.com.

This article is to remind member firms of their responsibilities under London Stock Exchange Rule 2101 (PDF) and associated guidance, particularly with respect to the appropriateness of passive limit order prices being placed onto our markets.

The majority of regulatory texts related to pre-trade controls relate to avoiding large order volumes or erroneous order prices which lead to immediate, aggressive execution – informally known as ‘fat finger’ errors. In more recent times, such a scenario tends to be as a result of a misconfigured execution algorithm or technical issue which immediately executes at an inappropriate volume and/or price.

Recently London Stock Exchange (the Exchange) has identified examples of passive orders which had a material impact on respective uncrossing prices of non-continuous trading periods. In various instances the Exchange observed relatively small passive orders being entered into the order book at price levels which were significantly away from the current market valuation, or any reasonable historical trading range. In an ordinary environment the insertion of such an order would simply sit at the boundaries of the order book without any impact, however, in periods of extreme market volatility and reduced liquidity such orders can materially impact execution prices. Not only does the order placement in itself create a potentially illogical uncrossing price, extreme indicative auction prices may also be exacerbated by automated trading or via direct market access whereby a number of unrelated algorithms place further orders at the new high/low set by the original passive order.

The Rules of the London Stock Exchange (“the Exchange”), including those of the London Stock Exchange Derivatives Market (“LSEDM”), stipulate that member firms must have adequate systems and controls in place to prevent the entry of erroneous orders to the trading system (see Exchange Rule 2101 and LSEDM Rule 4.1.4).

The purpose of this article is to highlight the importance of member firms maintaining appropriate pre-trade controls in order to prevent the submission of erroneous orders into the trading system which have the potential to cause short-term market dislocation, particularly in relation to the Exchange order book. The Exchange would like to stress to all member firms that Exchange circuit breakers or volatility constraint mechanisms, such as the Automatic Execution Suspension Periods (“AESPs”, commonly referred to as circuit breakers), should never be relied upon to deal with erroneous orders, or used as an alternative, to in-house pre-trade controls.

Erroneous orders can have a significant impact on trading across single and multiple instruments and erroneous program trades (also known as basket orders) have a particularly high potential to cause trading disruption, primarily due to the nature of their order entry and execution. These execution factors include multiple instruments selected in a single dealing instruction, large notional basket values at closing/expiry auctions and the general ‘wave’ functionality of program execution, whereby multiple similar waves of orders can be entered into the market.

Early in 2014, the Exchange introduced the Member Controls Oversight Programme (“MCOP”). This was established in response to the publication by the FCA in August 2013 of finalised guidance on ‘Market Operators’ oversight of member firm compliance with rules’. This guidance outlines the approach the FCA expects recognised investment exchanges (“RIEs”) and multilateral trading facilities (“MTFs”) to take to ensure on-going oversight of the systems and controls which their member firms operate to comply with the RIE’s or MTF operator’s rulebook.

All market operators are required to have in place proactive, effective, proportionate and risk-based arrangements in order to be able to determine that their members’ systems and controls can be reasonably expected to ensure compliance with the respective market operator’s rules and trading procedures by both new and existing members.

The Exchange’s MCOP is based around a programme of reviews of an identified population of firms over a six-monthly cycle. Firms which are selected for review are required to complete a systems and controls questionnaire covering matters such as the pre-trade controls they operate during each trading phase for each type of order flow; the monitoring by the firm of its trading activity; automated trading management; and how firms ensure that trading staff are sufficiently aware of the Exchange’s rules. Following receipt and review of each completed questionnaire, the Exchange determines whether clarifications are necessary and/or whether further discussions are required, either in a meeting or conference call.

It is important for the Exchange to ensure that its member firm records remain up-to-date so that it has access to the correct information in the event of queries and problems.

Changes in authorisation

Exchange Rule 1010 and LSEDM Rule 1.1.2 state that “A member firm must at all times be authorised under relevant United Kingdom, or appropriate overseas legislation, or in the view of the Exchange be otherwise sufficiently regulated, in respect of capital adequacy, and fitness and probity”. Therefore, any changes to a member firm’s authorisation, such as a loss of authorisation or related permissions, must be notified to the Exchange. This notification should be immediate in accordance with Exchange Rule 1050 and LSEDM Rule 1.1.20 which state, that “A member firm shall, immediately upon becoming aware of any circumstances which have, will or may lead to a contravention of any of the rules…notify the Exchange of such circumstances in as much detail as is available to it”. Failure of a member firm to notify the Exchange in such circumstances may result in a breach of this rule by the member firm.