The integrity of futures markets: The impact of price limits on futures prices

Introduction Defaulting traders, market crashes and asymmetric information problems attract negative attention to the integrity of derivatives exchanges. As a result, calls for further regulation arise with almost every large realignment of market values. Regulation clearly responds to the trading behaviour of market participants. Whether or not trading behaviour is also affected by regulation has so far largely been neglected.1 When traders are confronted with market impediments, they will revise their expectations accordingly. This affects their order flow and, hence, the volatility of prices. Evaluations of the impact of market regulations on the price discovery process that consider the trading process exogenous ignore these dynamic adjustments. If trades are diverted to other outlets (such as non-regulated options or the cash market), this may lead to increased volatility and a reduction in order flow. Thus, the 'integrity' of the exchange can even be further endangered as a result of the trading impediments invoked by regulation. A proper cost-benefit analysis of the imposition of regulatory tools therefore needs to assess trading behaviour dynamics. Before elaborating on our approach, it seems worthwhile to first define the type of regulation on which we will focus.

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