Trading in financial markets during a pandemic – some initial thoughts

"It's 2008 all over again", said my Simmons partner Darren Fox, as, having heard the news of coronavirus cases multiplying exponentially across Europe, he contemplated a day advising clients on the short selling bans announced by Italian, Spanish, UK and other regulators in an attempt to stabilise the volatile markets of last week.

Actually, on Thursday 11 March 2020 things looked even worse than in 2008 - at least by some measures. The FTSE 100's dropped 9.2% in one day. It was the worst since the 10.8% drop on Black Monday - 22 October 1987 and the quickest fall in the bear market ever. Morgan Stanley's chief US equity strategist said in a note: 'We are now trading slightly below our downside case on the S&P 500 and believe it is time to start adding to equity risk for longer term investors.' Markets duly recovered somewhat the next day. But it's not over yet. Given the advice from the UK's Chief Medical Officer that the coronavirus outbreak might peak in 10 to 14 weeks, what is the outlook?

Although the market gyrations may look similar than in 1987 and 2008, the underlying cause of the current volatility is fundamentally different. Unlike 1987 or 2008, the downturn was not caused by political or financial factors. There were no out of the ordinary economic policy announcements. Banks are well capitalised. Even if the political response to the crisis is having an impact on the markets, the underlying cause is a health scare; a pandemic. Click here for our analysis of the likely economic scenarios.

Given the widespread health impact and governments' responses, one of the key concerns for financial market participants is operational resilience and business continuity. Trading in 2020 looks very different than it did in 1987 and has moved on significantly since 2008. Now, unlike then:

• very little trading is done in large exchange trading floors and electronic trading has become much more widespread than voice trading;

• following the reforms introduced by MiFID1 and MiFID2, there are now many more trading venues, from regulated markets to a proliferation of multilateral trading facilities (MTFs) and organised trading facilities (OTFs); and

• many more instruments are traded on venues. 

How might the 2020 financial market infrastructure hold up during a pandemic? Will trading itself grind to a halt, and if it does, what then?

These questions are also pertinent looking forward, in the light of plans by regulators to strengthen regulation of firms' operational resilience, including third party dependencies for key business services, coupled with plans by some to make trading venues even more important for trading: ESMA's consultations, published 4 February 2020 and 10 March 2020, suggest that the share of OTC and systematic internaliser trading of trading in the EEA is, despite the share trading obligation in MiFID2, in their view, still too high. ESMA also questions the number of transparency waiver requests for dark pools and posits various alternatives for limiting the availability of waivers.

Plans to continue trading

With the current market volatility, some have questioned whether governments should close exchanges. The general perception is that pro-longed closures would have severe negative effects on investments – it would become impossible to manage existing positions and run investment strategies. In the past, markets were closed temporarily in response to war or terrorist attacks. Suspensions may also be needed now. Trading venues all have – and must, under MiFID2 have – measures in place to ensure a proper market, such as circuit breakers and volatility auctions. Assuming the markets will stay open subject to such temporary suspensions – can they, from an operational perspective?

The operators of the few trading floors that remain – those in Chicago and those of the London Metal Exchange (LME), the last open-outcry trading venue in Europe - have announced contingency plans: CME Group asked members to test remote connectivity and then, on as of 13 March, closed the Chicago trading floors. LME considered moving the Ring to Chelmsford, but announced on 17 March that it will close the Ring temporarily from 23 March – for the first time since World War 2 – and move to full electronic price determination.

Electronic systems might themselves prove vulnerable if neither members nor trading venue staff can work from their usual locations. Some trading venues have by now successfully tested whether they might continue operations if all their infrastructure, operations and surveillance systems were run off-site. That is reassuring, but without the members, and in particular its liquidity providers, any trading venue would grind to a halt. This has proven a little more difficult as firms divide trading teams between teams working in the City or Canary Wharf, elsewhere in London or the UK, or even from home. The FCA has said it expects firms "to be able to enter orders and transactions promptly into the relevant systems, use recorded lines when trading and give staff access to the compliance support they need. If firms are able to meet these standards and undertake these activities from back-up sites or with staff working from home, we have no objection to this." 

Data from Simmons & Simmons Trading Venue Reviewer suggest that trading venues do not typically have rules requiring traders to work from specified locations. Effectively, if the firm can supervise traders working from locations other than those they normally use, and they continue to use the trader IDs allocated, there should be no objection. Eurex does have a rule requiring members to give it 14 days' notice of traders relocating but announced that it would relax this rule in response to the coronavirus crisis. Firms view the absence of requirements to tell trading venues of changes in location as permission to move the location of its traders and systems out of the relevant jurisdiction. For that to happen, members need to carefully consider their membership and the rules of the relevant venue. There might for instance, be a prohibition on traders accessing the venue from a particular location. Cross-border licensing also needs to be taken into consideration, this is an issue we expect UK firms to have considered already as part of Brexit contingency planning.

There are still several venues - especially in the fixed income and commodity markets, and most OTFs - that allow for voice trading. Clearly, in the absence of recorded lines, traders using these methods would need to be where the infrastructure is available - in the office, or at a back-up site if not from home. If remote trading at home, an option would be to build in remote recording solutions (eg software applications on mobile phones that allow for recording where calls are routed through the relevant application), or a way of dialling into the firm to record voice trades, but safeguards would need to be considered to ensure that staff solely use recorded lines. Helpfully, an FCA Statement dated 17 March 2020 accepts that in some emerging scenarios it will not possible for all calls to be recorded. Firms in such circumstances should make the FCA aware of this and consider risk mitigants if they are unable to comply with their obligations to record voice communications. For example, enhanced monitoring, or retrospective review once the situation has been resolved. Firms are also reminded to take all steps to be resilient to market abuse risks.

Alternatively, firms might consider whether there are alternatives to voice trading. Simmons & Simmons Trading Venue Reviewer captures when these might be available at the venue itself, in the form of electronic RFQ systems or auctions; or in other cases, an alternative venue might be available. 

If these back-up plans do not work, smaller and less liquid venues may themselves be at risk: under MiFID2, as MiFID2 requires at least "three materially active members or users, each having the opportunity to interact with all the others in respect to trade formation." 

Measures to ensure a fair and orderly market

The FCA has made it clear that it expects firms to take all reasonable steps to continue to meet their regulatory obligations. All European trading venues are required under MiFID2 to have in place a robust trading system, and sound rules, policies and procedures to ensure a fair and orderly market. Some - especially newer MTFs and OTFs have adopted very high-level rules giving the operator wide powers to suspend trading or cancel trades when markets are moving fast. Others - mainly the well-established exchanges - have detailed rules aimed at stabilising trading if needs be. These range from pre-trade controls such as limits on orders and price formation ranges to cancellation of trades and volatility auctions. Although the tools across venues are similar, they are not, as our analysis in Simmons & Simmons Trading Venue Reviewer reveals, exactly the same. Price ranges - meant to protect trades that fall within them - can also, and are sometimes, amended quickly. Under MiFID2, members and users are required to be aware of all these provisions. Under SMCR, the person exercising a firm's algorithmic certification function is specifically required to understand venues' rules. That knowledge might be tested in the current environment. 

If, as is possible, markets are closed when settlement and delivery is meant to take place, members need to be aware of what to do instead. A detailed understanding of the life of each trade is required. Are the trades cleared - in which case, members should consult the rules of the relevant clearing house or CCP, as by the settlement day, the CCP will have become the member's counterparty. Or are the trades meant to be entered into bilaterally between members? Many MTFs leave clearing and settlement to members to work out on a bilateral basis, but this means they do need to have a master agreement with their counterparties to address these matters. Simmons & Simmons Trading Venue Reviewer includes an analysis on trade formation, clearing and settlement allowing subscribers to understand, for each venue, who they are facing when the trade is initially entered into, and subsequently, as a consequence of the clearing process. Exchanges are now starting to publish further guidance on settlement – we suggest firms consulting the websites of those venues where they trade most often before trading start.

Force majeure provisions

Under English law, trading venues' documents - rules, procedures and so on - are essentially giant pre-printed contracts that cannot be negotiated unless the member or participant brings significant liquidity and the trading venue is less well established. In some European jurisdictions, notably Germany, the rules have public law rather than contractual status, but again, they are not to be amended by members. Many contain force majeure clauses, aimed at excluding liability of the operator should the venue not operate. Some venues have made these provisions two-way, others have not. Some have defined force majeure to include matters truly beyond the venue's control, but others stray into matters which should, arguably, be within their control, such as availability of the technical infrastructure. In some jurisdictions, such as France, wider drafted provisions may not always be relied on by the party seeking to escape liability. With the coronavirus crisis, it may soon be necessary to obtain detailed advice on the force majeure provisions included within crucial trading venues' rules. For a more detailed review of the law on force majeure and frustration see our article here.