Business discontinuity: an ongoing threat for financial markets stability
By Lorenzo Bracchi and Monica Moschioni, Market Hub, IMI Corporate & Investment Banking, Intesa Sanpaolo
Financial markets have undergone significant changes over the past decades. What strikes the most is the centric role of technology in driving change. Exchanges, once physical trading floors where traders would meet in person, have over time evolved into purely electronic trading venues.
The electronification of the whole investment process, from order entry to settlement, has boosted efficiency, execution speed and market volumes growth as a direct consequence. However, heavy reliance on technology implies a new threat to face: market discontinuity risk. Market activity breaks happen when regular operative processes are disrupted or suspended, following technical or operational failures on exchanges, on technological micro-infrastructure, on hardware, on software, or on inter-banks communication systems. The discontinuity risk can have an impact on the entire supply chain, so market participants are required to monitor any threat and revise their workflow constantly.
On one hand, technological progress is making exchanges increasingly resilient, but on the other hand, the growing complexity and interoperability of financial markets amplify the cost of any new operative interruption, especially if a lit pool is impacted, compared to other liquidity pools. In fact, exchanges are usually liquid with a broad range of market participants that rely on their prices and on their stability. Furthermore, the disruption may be particularly damaging if it occurs to a trading venue without alternative trading venues available. Market disruptions that occur during the opening or closing auctions of a lit venue add further risks. That’s because the opening auction typically sets the initial price, while closing auctions are frequently employed as benchmarks for index calculation and pricing derivatives and funds. Operational failures in cash markets can also create spillovers into derivatives markets, since trading disruptions in the cash instrument underlying may affect the derivative instrument (or vice-versa).
Market disruptions therefore require firstly, an adequate response from trading venues in order to prevent, respond, recover market discontinuity and, secondly, regulators to ensure operational resilience, as a key priority. Many jurisdictions have published regulatory requirements, including rules, principles, and guidelines regarding business continuity.
Technological failures can damage exchanges, both in terms of lower trading revenues and higher reputational risk, but also harm investors in multiple ways. Market disruptions hinder trading opportunities, jeopardising hedging strategies and liquidity, leading to heightened volatility and wider spreads. System-wide, low resilience poses operational risks for participants, including uncertainties in best execution, delays in clearing, and impacts on margin requirements.
The FIA European Principal Traders Association (FIA EPTA), representing Europe’s leading principal trading firms, recently assessed the effects on liquidity of a partial interruption that in May 2023 temporarily excluded market makers from providing liquidity to a major pan-European exchange (Markets Without Market Makers – FIA EPTA, February 2024). By comparing liquidity in instruments impacted and unimpacted by the damage, they were able to observe empirically how the lack of liquidity providers caused wider spreads and therefore higher costs of trading for investors, highlighting the relevance of market makers on the robustness of European markets.
Regulators and stakeholders are aware of the cumbersome need to tackle digital disconnection, and in recent times they put forward consultations, recommendations, and studies to bring potential remedies to the table, such as markets co-operation or standard protocols, in order to put resilience at the top of the agenda.
In June 2023, ESMA published its final report on market failure, containing feedback on the consultation paper issued in late 2022 and covering communication protocols, closing auctions and reference price safeguard mechanisms. Respondents agreed on the communication principles set forth by ESMA. The perimeter of communication protocols is also a main concern of EU Regulation DORA (Digital Operational Resilience Act, entering into force in January 2025) whose main objective is to guarantee the technological resilience of EU financial institutions, in case of operational disruptions. The Regulation aims at creating a harmonised regulatory framework to strengthen security and communication between financial entities, including trading venues.
ESMA consultation respondents also agreed on NCAs having clear arrangements in place, and publicly available to ensure a closing auction takes place, given its importance in closing price formation. Arrangements can include delaying the closing auction or adopting the last traded price as official closing, but ESMA ruled out the requirement, formally set forth by – among others – CBOE Europe and Aquis in 2021 (Market of Listing Outages: An Industry Protocol for Continuing Trading on Alternative Venues – CBOE, 2021), and of nominating alternative venues to conduct closing auctions.
Last December, the International Organization of Securities Commissions (IOSCO) also published a consultation paper on tackling market permeability and gathered responses until March. More precisely, IOSCO developed a survey to obtain feedback relating to break-events that occurred within its jurisdiction between 2018 and 2022. The report proposes five good practices to follow in case of operative disconnections. The focus is again on communication protocols and business continuity plans.
The document provides arrangements to foster clear and quick communication with the public in case of markets break, particularly regarding roles, responsibilities of each function, reopening strategies, and status of affected orders. It also suggests participants should prepare and update dispositions to guarantee closing auctions by means of delaying the auction time, or by any other means, that must be clearly set out in their business continuity strategy.
IOSCO also advises on post-mortem exercises to be shared with regulators to identify weaknesses and potential remedies. IOSCO recommendations and best practices have been issued to market participants and we can expect a final report soon. It will be interesting to analyse responses and compare them with other consultation reports, particularly with respect to the adoption of secondary ‘back-up’ venues. Supporters emphasise the operational advantage of having alternative venues, while others see it as too complex to put in place, especially considering that secondary venue prices often rely on those set-in primary markets. Trading venues and participants may also need to consider their broader operational resilience plans, such as business continuity plans (BCPs) and disaster recovery plans, to define their approach to resuming trading.
All jurisdictions require trading venues to have a BCP with defined policies and procedures to follow. Moreover, some jurisdictions reported that their trading venues conduct periodic disaster recovery tests with market participants on emergency scenarios and that these exercises have proven useful in preparing the market for trading disruptions and strengthening market resilience. For instance, the US futures industry has annually conducted a disaster recovery test, initiated by the FIA after the 2001 terrorist attacks, involving mock trading sessions to evaluate industry-wide preparedness for business disruptions and assess communications connectivity and system functionality among market participants.
While it is impossible to eliminate the risk of operative discontinuity, modern technology can help prevent and manage them. Trading remains the most visible part of the entire supply chain and consequently draws significant attention.
The risk of business discontinuity is not only a pan-country threat, but it involves every market participant, even if at different levels. It is important, for markets to be able to face this risk, to develop a strong collaboration between jurisdictions worldwide, and also a quicker and more efficient communication net, as well as the implementation of technological solutions to improve market resilience.
©Markets Media Europe 2024
