Regulating Trading Practices

Andreas M. Fleckner

Max Planck Institute for Comparative and International Private Law; Max Planck Institute for Tax Law and Public Finance

2015

Oxford University Press, The Oxford Handbook of Financial Regulation, Forthcoming

Working Paper of the Max Planck Institute for Tax Law and Public Finance No. 2015-8

Abstract:

High-frequency trading, dark pools, front-running, phantom orders, short selling — the way securities are traded ranks high among today’s regulatory challenges. It has become commonplace, both in financial and in academic circles, to call for the government to intervene and impose order. From a historical and empirical perspective, however, many of the recent developments look less dramatic than some observers believe. This is the essence of the present chapter. It 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. The chapter’s 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.

Regulating Trading Practices – Introduction: Standardization, Self-regulation, and State Intervention

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 common-place, both in financial and in academic circles, to call for the government to intervene and im-pose 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.

How and why the leading jurisdictions regulate trading practices is best understood by looking back in time. Two key developments mark the beginning of today’s regulatory regime: the rise of exchanges and the standardization of trading. Markets with features of an exchange first appeared at the end of the Middle Ages when merchants founded permanent institutions where they could meet, chat, and trade (eg, in Amsterdam or Frankfurt). Other exchanges emerged under mercantilism (for instance, in Berlin and Paris), still others as late as during industrialization (such as the London and the New York Stock Exchange). Over time, those who met at the exchanges began to establish rules, either by tacit custom or explicit enactment, to standardize and thereby facilitate their trading. They decided, inter alia, who is given access to the exchange (for example, traders, broker-dealers, market-makers), which items are admitted to

trading (such as stocks, bonds, and commodities), how transactions are concluded (bilaterally or through intermediaries, in periodic auctions, or in continuous trading, etc), and what provisions they are subject to (general terms and conditions, usages, customs, Börsenusancen). The significance of this standardization process can hardly be overrated. In fact, that selected individuals deal in negotiable items following specific routines turned out to be the decisive feature to distinguish exchanges from other markets and fairs.

Due to the identity of those setting the rules and those subject to them, trading on exchanges became one of the first examples of ‘self-regulation’ in the financial sector. It is true that hardly any exchange has ever enjoyed pure self-regulation because state intervention dates back to the earliest days of trading. Famous examples include a Dutch decree forbidding naked short selling (1610), an English Act restraining stock brokers and dealers (1697), as well as three Prussian orders excluding certain securities from trading (1836, 1840, 1844). But until about a century ago, legislators around the world remained principally silent, and most trading rules arose from self-regulation.

What followed can be described as a global movement away from self-regulation towards state intervention and supervision. The landmark statutes were the German Börsengesetz (1896),6 the US Securities Exchange Act (1934), and the UK Financial Services Act (1986).8 Originally, most statutory provisions focused on the organization of the exchanges rather than on the process of trading. Over time, however, a hybrid system emerged with more and more government rules that directly police certain trading practices, most recently high-frequency trading and other forms of algorithmic trading. By now, the trend towards state control has long reached the exchange’s very heart, the trading process, and those who invented the exchange, the traders. It will therefore be a recurring question throughout the Chapter, in almost all subsections, who is best prepared to address the regulatory problems that arise from trading: the government from afar or the traders on-site. While much has changed since merchants started standardizing trading practices in the Middle Ages, finding the right balance between state intervention and self-regulation has remained the principal challenge.