Most years, when the world’s exchanges meet to talk shop, few outsiders pay attention.
This time was different. The World Federation of Exchanges gathering in Vancouver this month came almost a year after the collapse of Lehman Brothers plunged the world into financial crisis.
As a result, regulators and policymakers are engaged in a thorough re-examination of the structure of the financial system.
At the centre of that system lie market structures such as exchanges, trading platforms and the post-trade services that support them. The way they performed throughout the crisis holds lessons for policymakers as they contemplate sweeping reforms to the way markets function.
William Brodsky, WFE chairman – and chief executive of the Chicago Board Options Exchange – said: “All the systems worked well – and the markets that weren’t regulated had many issues. It is our obligation as custodians of a public trust to make sure that the regulators understand what worked and what didn’t.”
Exchanges have been accused, by some, of seizing on the new regulatory mood in Washington and Brussels to promote their businesses.
There is probably an element of truth to this. But at the same time there is no denying the financial crisis has not only highlighted that exchanges functioned well relative to the off-exchange markets Mr Brodsky was referring to.
The issue has also led to a far-reaching – and controversial – debate about how assets of many kinds should be traded.
In many ways, it all boils down to transparency – or lack of it. Mary Schapiro, chairman of the Securities and Exchange Commission, says: “During the crisis, investor confidence in the transparency of the markets, sufficiency and even the reliability of the information they were getting was shaken to the core.”
Washington and Brussels have seized on the dysfunction of many parts of over-the-counter (OTC) derivatives markets and how this exacerbated the crisis.
In June, the Obama administration unveiled proposals for the reform of such markets.
The US Treasury wants to regulate both derivatives dealers and derivatives markets themselves. Banks that deal in derivatives would be required to meet capital standards and margin requirements to help lower risk. To promote transparency, a comprehensive reporting and recordkeeping regime should be established for swaps.
The US administration also wants to make it mandatory for all “standardised” derivative products to be cleared by a central clearing house to lower risk. Market transparency and efficiency is to be improved by “moving standardised OTC derivatives on to regulated exchanges or regulated trade execution facilities”.
The European Commission has come out with similar proposals.
Much of this has been cheered on by the exchanges, which have long had an uneasy competitive relationship with the much larger OTC markets. In theory they stand to benefit from any shift on-exchange.
But the issue of forcing more transparency into the OTC derivatives markets has sparked scrutiny of trading practices far beyond the confines of the OTC world. The SEC has embarked what on Ms Schapiro calls an “in-depth review of multiple market structure issues given the rapid advancements in technology”.
It is considering a ban on a type of order known as “flash orders”, is examining “dark pools” and high frequency trading, as well as “direct market access” and “co-location”.
High-frequency trading is a form of rapid-fire trading that seeks to eke out profits from the tiniest pricing differences between assets traded on exchanges and other platforms. Critics argue that participants armed with sophisticated technology have an unfair advantage over ordinary investors.
Proponents of high-frequency trading – which is done not only by such firms as Getco of Chicago and Optiver of the Netherlands, but also by banks – argue that without the liquidity they provide, investors would be worse off.
They also say that technology has always given one investor an advantage over another and this is no different from how markets have always worked.
Then there are “dark pools”, facilities that – in theory – allow large blocks of trades to be done, at a time when orders are getting smaller on exchanges, making it harder for many asset managers to perform large trades.
These platforms add another layer of complexity to the bewildering number of trading venues. In the US, Bats Exchange and Direct Edge have challenged NYSE Euronext and Nasdaq OMX in equities trading, while in the European Union, the “Mifid” reforms have spawned a slew of “multilateral trading facilities” such as Chi-X Europe, Turquoise and a European arm of Bats.
In Europe the resulting fragmentation of liquidity has made it hard for investors to know if they are getting best prices for deals.
More controversially, the growth of dark pools run by banks has sparked a war of words between exchanges in Europe and the banks. The Federation of European Securities Exchanges argues that too much share dealing has shifted on to such venues, which operate “with full opacity”.
They retort that their dark pools are not only regulated but provide a service to institutional investors and provide liquidity.
If the reshaping of market structure is inevitable, as concerns over transparency persist, it is also true that the financial industry and others – while accepting that more regulation is inevitable – have concerns that it could go too far.
Companies worry that the push for more clearing will make it dearer to use OTC derivatives, constraining their ability to hedge fuel and commodities.
Patrice Blanc, chief executive of Newedge, the world’s largest futures broker, says that: “If it does not make economic sense to clear OTC transactions nobody’s going to do it.”
Ultimately, any new regulatory framework will have to balance calls for greater transparency with a need to preserve what all protagonists can agree are the best parts of the markets.
Anthony Belchambers, chief executive of the Futures and Options Association, says: “This whole tension is between safety and innovation.”
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