Occasional tremors in financial markets had been evident over the past year or so, and again in July this year. It was impossible to tell whether they constituted a gradual release of pressure on risk premia that had become overly compressed, or whether they signalled a more disruptive movement to come. On August 9 the question was answered. As if to highlight the global nature of the crisis, the unexpected revelation by a French bank that its investment funds could no longer value their exposures to US sub-prime mortgage loans produced a sharp reappraisal of the risks they were taking by investors around the globe. The returns demanded by investors on all risky assets rose – from packages of bank loans to plain vanilla company shares – so the prices of those assets fell. And in some markets for complex financial instruments, investors realised that perhaps they did not understand as much about the nature of the risks involved as they should. So not only did asset prices fall, but the markets in some of these instruments virtually closed. There were no buyers. This freezing of capital markets led to a chill in banking systems around the developed world. Banks that had relied on selling packages of loans in securitised form found that they couldn’t sell them. Investment vehicles that held securitised loans have found it difficult to finance their holdings by borrowing.
As with road traffic congestion, one way to tackle that would be to place direct restrictions on excessive message traffic – for example, by setting maximum order cancellation ratios. The US Securities and Exchange Commission (SEC) are considering this option. So too are the authorities in Europe under the draft proposals contained in MiFID II. These are welcome moves. New trading topologies also run the risk of turning the miracle of higher liquidity into a mirage in situations of stress. One potential response would be to strengthen market-making commitments. The past few years have seen a dilution of some of those commitments. For example, in 2008 the New York Stock Exchange relaxed its market-making commitments on maximum bid-ask spreads. One upshot was that, during the Flash Crash, the prices of some stocks hit zero and others $ – so-called “stub quotes”. Following the Flash Crash, the SEC moved swiftly to ban stub quotes. This effectively re-introduced a requirement for market-makers to ensure price continuity. It has also been considering enhanced market-making obligations or incentives to improve the resilience of market liquidity in situations of stress. In Europe, MiFID II is looking at the scope for strengthening market-maker commitments for similar reasons. This would be a welcome turning-back of the trading clock – a clock otherwise at risk of running too fast. Strengthening circuit-breakers across exchanges can also help to restore market order in situations of stress.