The World Federation of Exchanges (WFE), the global industry group for exchanges and central counterparty clearing houses (CCPs), has called for the International Organisation of Securities Commissions (Iosco) to set out recommendations for authorities and exchanges to consider when designing and implementing volatility control mechanisms (VCMs) to manage extreme volatility, enhance investor confidence, and contribute to the maintenance of trust in financial markets, and the preservation of orderly markets.
In response to the regulator's consultation report on 'Mechanisms used by trading venues to manage extreme volatility and preserve orderly trading', the WFE agreed that avoiding a one-size-fits-all template for volatility control is important, and encouraged policymakers and regulators to adopt a flexible, principles-based approach.
'Venues must have the ability to tailor and improve systems and controls to meet the needs of their markets and market participants as circumstances dictate,' stated the WFE. 'VCMs are most effective when the costs and benefits of interventions are carefully analysed. The efficiency of these tools should be regularly examined against their objectives.'
The exchange's trade body also pointed that market participants, meanwhile, must have their own systems and controls to manage risk and ensure appropriate protection for their clients, taking into consideration the relevant market conditions, including market liquidity; market volatility (in consideration of volatility drivers and characteristics); levels of algorithmic trading; available order types; market-maker rules and; linkages between derivatives and underlying assets.
Beyond common derivatives, contracts may be linked to a great variety of other assets or indices, tracking things like the volatility of the stock market, the weather in a particular region, or the cost of freight transport, according to the WFE.
'Firms that are exposed to the risk of a movement in the price of these assets, may use derivatives to manage this risk,' it said. 'The counterparties to these contracts may be businesses with opposite risks, speculators who take view on the future price of underlying assets, arbitrageurs who sew together fragmented markets or market-makers who hold assets in inventory and profit from the bid/ask spread.'
From this perspective, investors in structured products featuring risk and volatility control indices have a better chance to navigate periods with spikes in volatility without incurring in capital loss. SRP data shows that over 3,000 structures have been marketed across jurisdictions globally of which over 2,000 are still live. More than 140 risk and volatility control indices have been used in structured products.
Germany (614 products) is the country with the highest number of products featuring volatility control indices, followed by Canada (489), Sweden (429), the US (406), and Belgium (261). The most utilised risk and volatility control underlyings from an issuance perspective is the S&P/TSX Composite Low Volatility Index (445 products), followed by the S&P 500 Low Volatility Target Beta Index (175 products), S&P Europe 350 Low Volatility (112 products), iStoxx Europe Next Dividend Low Risk 50 (86 products), and S&P Bric 40 Daily Risk Control (80 products).
From a derivatives manufacturer stand point, the most active issuers providing risk and volatility control structures are Commerzbank, RBS (no longer active in the market), UBS, Societe Generale and BNP Paribas; whereas the most active distributors of such strategies are Commerzbank, BMO Financial, BNP Paribas, JP Morgan, National Bank of Canada (NBC), and Shinhan Financial.
Volatility has also an impact on the pricing of products so the higher the volatility, the better the payoff and pay-out schedules offered to investors as the issuer's upper limits go up which enables them also to lower downside barriers, whereas low volatility makes options embedded in structured products more expensive.
In the US market, indexed annuity sales have increased significantly year on year on the back of volatility control indices which now represent around 23% of fixed index annuity (FIA) sales across over three dozen volatility control indices.
The association noted that the extreme volatility in the Canadian equity market on August 24, 2015 showed that prices for leveraged ETFs needed to move in wider increments; hence, the Investment Industry Regulatory Organisation of Canada (IIROC) increased the single-stock circuit breaker trigger thresholds to accommodate for the increased potential volatility of these types of securities. Another example provided by the regulator showed that Bursa Malaysia Derivatives made changes to the dynamic price limits (DPL) on structured warrants due to frequent requests by its participants to widen the thresholds as the limits were impeding trading opportunities.
The WFE also welcomed the regulator's recommendations regarding the co-ordination between trading venues during periods of market stress, and pointed that exchanges should also retain the flexibility to determine the appropriateness and form of communication to market participants and the wider public when a mechanism is triggered.
Volatility controls are a means to ensure investor protection and appropriate price formation and should be deployed with these objectives in mind, according to the WFE. 'The interests of an orderly market should be central to the design, calibration and implementation of volatility controls,' it said, adding that trading venues should retain discretion on imposing any volatility controls, taking into consideration individual product characteristics and their respective market dynamics, as intervention might undermine market efficiency.
According to the WFE, trading venues should also ensure that volatility control mechanisms are appropriately calibrated via a series of non-exhaustive list of elements including the nature of the financial instrument or underlying asset e.g. a security, ETF or derivative; the liquidity or trading profile of the financial instrument; the volatility profile of the financial instrument or underlying product; the volatility control mechanisms in place for related financial instruments and/or markets; and the price of the financial instrument.
'Volatility controls can effectively protect investors, and contribute towards market integrity, aims which are core to exchanges' social purpose,' said Richard Metcalfe (pictured), head of regulatory affairs, WFE.
Click in the links to read the full response to Iosco, the WFE report.
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