Financial markets can provide extraordinary benefits when they work well. They enable participants to raise capital, invest, hedge or speculate with safety, with great convenience, at low cost and with privacy. But these benefits may fail to accrue when markets do not work well. A lack of liquidity, for example, can make it difficult for a participant to get a fair price when liquidating a position -- which reduces the safety of that investment.
The issue of most concern to potential participants in any given market is the orderly conduct of the market. A disorderly market -- for example, one suffering massive price swings with no apparent cause -- is an extremely dangerous one for participants. For this and other reasons, financial markets have long been regulated, both by national and international institutions and by individual marketplaces.
At the national level of regulation, regulators are mainly concerned with the behaviour of investment banks and brokerages with respect to their customers, rather than with the operation of the markets. Regulators are concerned that customers are being advised correctly and not defrauded, and that banks and brokerages are not running risks that could threaten the stability of the entire system of financial markets. International regulation takes the concern with systemic risk further and is concerned with economic stability.
Individual marketplaces, in the form of exchanges, regulate their markets through their rules and procedures. Exchanges often have self-regulatory status, reporting to national and international regulators, and market surveillance by exchanges is normally a key requirement of their self-regulatory status. This is not just a philanthropic concern for the well-being of fellow men, but a result of the recognition that people do not shop in markets if they think they are going to get their pockets picked or be ripped-off by the stall holders, and that stall holders will be reluctant to operate in any market where they think their fellow stall holders will rip them off. An orderly market where all participants feel safe is in the best interest of the vast majority of market participants. Exchanges are constantly on guard for attempts by members and their customers to manipulate and subvert the market, at the expense of other market participants.
Market surveillance by exchanges is not generally concerned with the behaviour of brokers with respect to their customers, as national regulators are typically responsible for this element of regulation. Rather, exchange market surveillance is concerned with orderly markets, transparency, level playing fields and investor safety. Exchanges deal with the 'grown-ups' -- the professionals at the centre of the market rather than the end-users who are the customers of these professionals.
An orderly market will reflect the interplay of buying and selling interest in the investments involved, and trades in such a market will be exposed to the normal pricing mechanisms of the exchange. Whilst it is difficult to specify the conditions that could constitute 'market abuse', they can generally be recognised by the distortion they create in price movements and the resultant weakening of the reliability of price formation processes. One example would be the use of misleading statements to induce participants to buy or sell. Another would be the use of large positions to squeeze a market.
The existing regulatory influences are largely effective in maintaining orderly markets, but they cannot prevent all antisocial behaviour. As in any other sphere of life, the bad guys are a step ahead of the police, and regulators face ever-changing and ever-growing forms of market abuse.
Effective market surveillance is becoming more difficult
One of the major factors driving change in the regulators' environment is the increasing globalisation of the financial markets. Investment banks and major brokerages have been operating globally for many years. Derivatives contracts or near equivalents have been cross-listed on exchanges with varying degrees of success, allowing trading to follow the sun around the globe. Companies have sought global markets for their equity by listing on multiple exchanges. Exchanges -- traditionally regional markets -- have started to get in on the globalisation act. Exchanges first tried alliances across borders, allowing cross-listing of instruments. Demutualisation then raised the globalisation game for exchanges, allowing full-blown takeovers, mergers and joint ventures, so corporate exchanges can have branches around the world. Investors are also getting in on globalisation, and demand is increasing for cross-border trading.
Alongside increasing globalisation comes the increasing possibility of cross-market abuse. This type of abuse has been known about since the early days of derivatives exchanges. 'Triple-witchings', where there is a conjunction of expiry dates on related instruments, are dangerous times in the market. Slight price movements can be amplified as positions are adjusted ready for delivery to commence. Such conjunctions are ideal opportunities to manipulate across markets, where there is less chance of being detected. Exchanges were aware of this, and were not only extra vigilant during these periods, but actively tried to avoid conjunctions in expiry dates for related instruments.
It is difficult enough for cross-market abuse for related instruments to be prevented or detected when all the instruments involved are traded on the same exchange, but the situation is worse if they are traded on different exchanges. For example, UK equities are traded at the London Stock Exchange (LSE), but options on many of the major London-listed firms are traded at the London International Financial Futures and Options Exchange (LIFFE). Activity in the LIFFE market for options in an LSE-listed firm can and will affect the LSE market for the underlying shares, and vice versa. This means that market surveillance units at both exchanges cannot afford to ignore market activity at the other.
It gets worse. Many financial instruments are not traded on an exchange but are traditionally traded on telephone markets. This includes over-the-counter (OTC) derivatives that can be closely related to exchange-traded instruments. If we replace the LIFFE-traded equity options in the example above with OTC options then it is difficult to see how the LSE can gain sufficient information to prevent cross-market abuse.
The equity markets and those for these related instruments are by no means the most susceptible to market abuse. Perhaps the most obvious target for those intent on manipulating markets is the commodity derivatives world. It's likely that commodity markets have been prone to corners and squeezes since pre-historic times, and the advent of regulated exchanges only meant that the most unsavoury behaviour moved off-exchange. OTC markets, by definition, have no exchange mechanisms to detect market abuse or enforce regulation and many OTC commodity markets are closely connected with exchange markets for the same commodities. This means that a party intent on squeezing an exchange market can conduct much of his trading in the associated OTC market -- free from surveillance and maybe even from prosecution.
In one example a rogue copper trader at Sumitomo conducted a series of campaigns to manipulate the copper market over many years. His activities led to excessive price movements on the regulated copper markets including the London Metal Exchange (LME) and New York Mercantile Exchange (NYMEX), even though his trading was largely confined to OTC markets.
The high potential for abuse of such markets stems from:
- The existence of multiple exchanges, plus the OTC market
- The close connections between markets in futures, forwards, swaps, options and other derivative instruments
- The relationship between the derivatives markets and the physical market.
It is this last factor that makes the commodity markets so susceptible to abuse -- the physical limits on supply of physical commodities mean that significant stockpiling or building of large positive positions in futures will result in shortages and hence in upwards pressure on prices. Consumers typically cannot just switch to an alternative commodity as such a change may require industrial changes that take years or decades, even if an alternative exists.
Although the commodity derivatives markets are the worst affected, the ever-expanding array of financial instruments results in similar difficulties in most financial markets. Returning to equities, for example, there are individual equity options, equity index futures and options, swaps, contracts for difference etc. Trading in these different instruments is fragmented across a number of marketplaces, all influencing and influenced by each other, with a patchwork of regulation providing variable and fragmented coverage.
So, the increasingly global nature of exchanges, instruments, brokerages and investors, and the fragmentation of trading across different platforms, both suggest an increasing potential for cross-market subversion and manipulation. But market surveillance and regulation seems to be the only aspect of the financial markets that is not going global. Should it, and will it? And if not, why not?
Global market surveillance is not the answer
In fact, despite the seemingly strong case for it, global market surveillance and regulation is not desirable, achievable, or necessary. The best approach to maintaining orderly markets is to provide the means for market participants to police themselves --transparency -- and to increase the effectiveness of internal controls within firms that participate in the markets.
Global market surveillance is not desirable
Why is global market surveillance not desirable? Although market participants are the beneficiaries of orderly markets, there is generally a tension between the participants and the regulators. For a start, it's the market participants that pay for the surveillance, through increased exchange and other fees. They are also obliged to incur other costs, including IT and personnel costs to support the compliance function. More than the costs, however, it is the restriction on their activities that irks the banks and brokers. Businesses of all types thrive on freedom and choke on red tape -- what market participants want is less regulation, not more.
Global market surveillance is not achievable
Even if a global cross-market approach to surveillance were desirable, most commentators believe it would not be possible. Political considerations and self-interest make all cross-border co-operation of this type difficult. Who would control a cross-border market surveillance organisation? To whom would it be responsible? For any country to concede control over its own financial markets to an international body would also represent a loss of face and a diminishment of sovereignty. More seriously, in times of trouble it could represent a potential threat to national economic well-being.
Even within a nation, it can be difficult to consolidate surveillance across markets. The UK now has a single Financial Services Authority, but the eight Recognised Investment Exchanges are each responsible for surveillance of their own markets. The US case, and, in particular, the issue of single stock futures, is particularly instructive. Cash equity trading is regulated by the Securities and Exchange Commission. Derivatives trading is regulated by the Commodity Futures Trading Commission. So which of the commissions should regulate trading in single stock futures? The futures market in an individual equity is more than just related to the market in the equity itself -- it is really another manifestation of the same market. The turf war between the two commissions led to a stalemate culminating in the Shad-Johnson accord that prohibited the trade of single stock futures, essentially because the regulators couldn't decide who would regulate the market! This stalemate seems now to have finally been resolved and the two commissions have agreed a joint approach, but, at the time of writing, LIFFE still awaits regulatory approval to offer their single stock futures contracts in the US.
Global market surveillance is not necessary
But don't the trends described earlier necessitate the establishment of global market surveillance, regardless of the cost or the difficulties of achieving this?
Let's take the Sumitomo affair. Since it resulted from trading across multiple markets and multiple jurisdictions it would seem to be a good example of the sort of situation that could have been prevented through global cross-market surveillance and through no other means. But most commentators think otherwise. OTC markets can only affect exchange markets where there is an overlap -- some traders must be active in both markets. This means that exchanges can use their regulatory power over members to force them to provide information on their OTC activity at times when market conditions indicate the necessity of such action. The fall-out from the Sumitomo affair resulted in significant fines for a number of major players, and the rules of the exchanges concerned have been further tightened since.
This means that global surveillance would not have been necessary to prevent the Sumitomo affair, had current rules and mechanisms been in place at the time.
In fact, some of the mechanisms that were put in place in the wake of the Sumitomo affair point the way towards a more promising approach to maintaining orderly markets. Many of the measures introduced by the LME were aimed at improving market transparency. For example, the LME now publishes reports showing the build-up of potentially market-dominating positions, and these help market participants to tread carefully at dangerous times. LME rules can be used to force market participants to trade at regulated prices if they are judged to hold dominant positions.
Further evidence that global market surveillance is not necessary may be seen by considering the case of markets that are not currently exchange-traded and hence do not benefit from market surveillance, except that provided by national regulators. Why is it that these markets run in an orderly manner? Is there anything to be learned from this?
The markets in question include some of the biggest and most important, such as the global foreign exchange (FX) markets and the bond markets. Although these markets have traditionally operated without an exchange, they do have a high degree of transparency. Information vendors such as Reuters provide continuous streams of data showing exactly what the market is doing at all times. In addition to the high level of transparency, there is also a community self-policing effect, as anyone caught manipulating these markets would find themselves excluded from further activity by the other major players.
So, there are arguments that global market surveillance is not desirable, achievable or necessary, and that increased market transparency can achieve many of the objectives of increased regulation. What else can be done to help ensure orderly markets? Can we get closer to the cause of disorderly markets?
Addressing the causes of disorderly markets
The Sumitomo affair turns out to have much in common with a number of other high profile catastrophes in the financial world such as those associated with Barings, NatWest Markets, and the recent AIB losses. Regardless of whether or not these incidents involved market manipulation, they all involved failures of operational controls in the firms for which the traders worked. Members of any exchange will have compliance departments responsible for ensuring that the company is not breaking exchange rules as well as national and international laws, so any attempt at market manipulation is a failure of internal compliance. In addition, compliance is a Group-wide issue across even the most global of financial institutions. So perhaps greater effort directed to supporting internal compliance efforts would be the most effective way of countering abuse of global markets?
Exchanges already 'assist' their members in ensuring compliance by performing regular or semi-regular audits of their processes, but the workload involved means that these audits are typically infrequent, allowing long periods when the exchanges are blissfully unaware of what's happening within member processes. Future changes to exchange regulation should be oriented towards requiring that members have adequate internal controls to prevent such operational failures (such as having front and back offices controlled by the same individual), and audits should focus on the competence and strength of these controls. The benefits to members of such attention will go beyond the strict remit of ensuring orderly markets and hence may seem intrusive. But catastrophic failures of exchange members are events that tend to disrupt markets regardless of whether or not the failure was caused by attempts to manipulate a market, so any extra effort to prevent such failures can be seen as falling within the wider remit of exchange regulation to maintain orderly markets.
In this article we have argued that global cross-market surveillance and regulation is not the appropriate response to the challenges faced by regulators in the face of increasing globalisation and the fragmentation of trading in related instruments across multiple platforms. We believe that a two-pronged approach of increased transparency and greater involvement by exchanges in member firms' internal operational controls represents a far more acceptable, cost-effective and achievable way forward.
