In an ideal world, each securities exchange would be a perfect market where buyers and sellers interact on equal terms and at optimal prices.
The extent to which any particular exchange approaches this ideal is of course difficult to establish – and even the most prestigious markets can occasionally exhibit irrational behaviour, as Peter Bennett discusses in his article for this edition of the Handbook (see Stock markets and catastrophic tendencies).
But even when markets are operating apparently efficiently, there can be many factors that interfere with the equality of interaction between participants – especially, disparities in information, knowledge and expertise. To an extent, such differences are inevitable and provide a beneficial incentive for the less knowledgeable or skillful to improve their performance. But where such improvement is not feasible, the imbalance between, for example, the occasional, small-scale investor and the market professional can be too great and, in the view of most, unfair.
It is this situation that is intended to be addressed by rules and regulations, introduced in many cases by the markets themselves or, where markets seem unwilling or unable to do so, by governments or government-appointed regulators. As the Investor protection section of each exchange’s entry in the Handbook shows, most developed markets are governed by such regulations, backed up where appropriate by legislation, which are intended to redress the imbalance by controlling the way in which the market operates.
And there’s the rub. How can regulations be implemented which control – and inevitably restrict – the way in which the markets operate, without at the same time making them less efficient, increasing their costs, and disadvantaging the very people that they were intended to help in the first place?
This is a conundrum that has been faced by regulators and markets since, at least, the response to the Great Crash of 1929 which led among other things to the setting up of the Securities and Exchange Commission in the US. Over the years the pendulum has tended to swing between ‘regulatory constraint’ and ‘market freedom’ – and at the moment the markets and their participants, especially in Europe and the US, are faced by a new wave of regulatory change. These changes, driven in part by regulators’ attempts to come to terms with the rapid technological developments of the last few years, include:
The EU’s Financial Instruments Markets Directive – popularly known as ISD-2 – covering, amongst other things, publication of prices and quotes by trading venues.
The EU’s Transparency Obligation Directive, improving the disclosure of information by listed companies.
The SEC’s proposed Regulation NMS, designed to modernise the regulatory structure of the US equity markets, including the prevention of ‘trade-throughs’. (For more information on this see Junius Peake’s article Regulation NMS: Pools or an ocean of liquidity?)
What effect will these changes have? In particular, will they have the desired result of levelling the playing field for all market participants; or will they simply introduce new barriers in the way of those who are already out there with the big roller?
Much will depend on the detail of the way in which the changes are implemented. Our feeling is that regulation is most successful when it sticks to matters of principle, and opens up the implementation of the principles to competition between different providers.
An example of this is provided by the model adopted in the UK for the distribution of news announcements by listed companies. Until April 2002, the London Stock Exchange was the sole provider of regulatory news in the UK. Its service was slow, old-fashioned, inconvenient for companies who needed to contribute news, and unfriendly for investors who needed to access it. In 2002 the Financial Services Authority opened the provision of regulatory news up to competition through a system of primary and secondary information providers. The result has been the introduction of substantially improved Web-based services, with basic information available to the public free of charge, but enhanced services available to those who are prepared to pay for them.
This model has also been adopted elsewhere. The final text of the Transparency Obligation Directive proposes competitive supply of regulatory information from issuers on a pan-European basis. Soon the only significant equities market retaining the monoploy model will be Australia.
It’s clear that this model has worked for the publication of news. Why could it not also work for the publication of prices?
One of the problems that the SEC is currently trying to address is the Intermarket Trading System (ITS), created in 1978 to implement the national market system and ensure that investors’ orders were channeled to the market offering the best price. As with many other monopolistic utilities, there has been no incentive for the operators of the ITS to innovate; and even if they had wanted to, who would have paid? The result has been stultification, with the ITS reduced to an ageing network that acts as a barrier to trading efficiency rather than promoting it.
If, instead, the pooling of liquidity that the ITS tries to bring about was handed over to the markets, competition between suppliers would drive innovation, and the commercial opportunities would generate the funding. In fact, a number of organisations have already made rapid moves in this direction. The information vendor Reuters has for some years been displaying screens which bring together quotes and price information from multiple trading venues; and the technology firm Lava provides services that integrate the order books from ECNs, exchanges and other liquidity sources and enables orders to be transmitted to all venues via a single interface.
The potential benefits of these changes for institutional investors are clear to see: innovation, greater choice, and control on costs resulting from competition. But where would they leave the individual that much regulation is designed to protect: the private investor?
Our view is that, as with regulatory news in the UK, there would still be a strong incentive for commercial, profit-driven suppliers to make a good quality information service freely available to the general public, not least for marketing and brand development reasons. And at the same time, it is reasonable to ask whether the perceived ‘needs’ of the private investor that have driven so much regulation are in fact valid. For example, how many private investors have the knowledge, time or inclination to make use of large amounts of detailed market information?
Regulation of course is necessary. But it should concentrate on protecting private investors, by establishing rules governing the conduct of those who deal with them, and should avoid impeding the operations of market professionals.
Above all, the most effective regulation comes from a detailed understanding of the way in which the markets work. Interaction and exchange between practitioners and regulators should be encouraged wherever possible.