(Ex-) Change
Until the late '80s, the world of Exchanges was a rather static one. They functioned essentially within their own jurisdiction, took care of their own technology (if any), as well as -- more importantly -- their own regulation. Governments hardly interfered. Competition was a word that Exchange managers frequently used but hardly ever practised, certainly not on themselves.
All this changed through technology and the demands of advanced (geographical) differentiation of portfolios. A key step in the competitive transformation of Exchanges was the daring decision of the London Stock Exchange, then with justification called 'the International Stock Exchange', to use its SEAQ International advertising screen to attract cross-border professional equity business to participants in the London market. This valiant effort to gain dominance in cross-border equity trading nearly worked, and could well have been successful had London at that time modernised its trading system and shown willingness to create alliances with others.
Following this, the European Stock Exchanges decided upon and implemented a drastic modernisation process that was nearly without precedence. The crux for all of them was to break out of their narrow jurisdictions by moving from the physical trading floor with limited numbers of participants to a virtual trading environment with unlimited participation and with a greater attractiveness for remote membership across all borders.
Regulation: ISD et al.
The Investment Services Directive (ISD) of 1996 contributed to these developments by facilitating remote membership. Most Exchanges reviewed their governance structures and transformed from member-owned, member-run, member-governed organisations to companies with the profit motive and competition as their main drivers. A few Exchanges have taken the step that may be called 'decisive' by listing themselves. Deutsche Börse AG, Euronext, London Stock Exchange and before them Stockholm and Sydney went 'all the way'.[1]
The ISD, the constitution of the European Union for the securities (and especially cash market equity) Exchanges was not the only regulatory innovation. The Insider Trading Directive of 1989 had forced EU members to set up and/or strengthen national Regulators to combat insider trading. These Regulators turned from small-scale supervisors operating at a distance into the active regulatory and enforcement organisations that they are today.
The pendulum is swinging from self-regulation with hardly any government interference towards over-burdening regulation and over-detailed -- but not overly-successful -- enforcement in a formalised context. It is to be hoped that common sense will prevail and that the virtues of (semi)-self-regulatory practices can be recognised again in the current discussions on new EU Directives. The record of official enforcement and prosecution is, to put it mildly, rather spotty; look at criminally punished money laundering, fraud, insider trading or other forms of market abuse.[2]
In many jurisdictions, Stock Exchanges, bond trading mechanisms, futures, options and commodity markets and also clearing houses and settlement organisations have joined under one single roof and management. These moves were prompted by advantages of scale, but also by the benefits of synergy and the one-stop-shopping services that could be offered.
Context
These changes took place in a drastically different context. In the past, the numbers of private investors were small, few new companies would come to market, and pension funds, if they existed at all, were focused on 'safe' government bond investments. The '90s showed a massive shift towards equity. Major pension funds in Europe followed the example of their American counterparts but fortunately with a lower dependence on investment in the company's own stock, as far as company pension funds were concerned).
Millions of new investors came into the markets due to demographic concerns, pushed by the realisation that equities produce better results for a longer period as confirmed time and again by independent research. The attractiveness of 'dot.com' riches and the massive advertisement of privatisations also played their part. Undeniably, the bursting of the 'dot.com' bubble, the failure of some privatisations to realise their promise, the September 11 events and Enron and similar mishaps have reduced enthusiasm somewhat. However, the longer-term positive developments seem quite clear. The market capitalisation as well as liquidity levels of a number of European capital markets are up to American standards, while some others still remain only in terms of market cap/GDP ratios.
It may be argued that the reinforced regulation and supervision has flowed, in part, from some of these mishaps. Iquestion, however, whether the inclination of governments to believe that their solution is the right one is always justified in terms of prevention, detection and effectiveness of enforcement.
Euro
In 1997, it became clear that European governments were serious about introducing the euro. The members of FESE decided to transit to the euro at the earliest possible moment and to do so in the fullest sense possible; a rather courageous joint step. The result, in which Exchanges from outside the euro zone also participated, was a flawless transition without any pressure, push or pull, by authorities. The ECB in Frankfurt must have been rather delighted with this show of confidence from the capital market organisers. Especially from a psychological point of view, the arrival of the euro has had a major impact on how capital markets are organised and how they will evolve. There is no denying, however, that there remain many barriers in the way of one single integrated capital market or capital market organisation. The introduction of the euro has also brought to the forefront a different, important and new player in the capital markets and that is the European Central Bank itself, through its participation in the money markets, its role running Target (the professional payment system), and its undoubted future role as Regulator and supervisor.
One of the interesting aspects of current market developments is that, in many areas, the lessons, experiences and mechanisms developed in and for the equity cash markets are being copied, whether in futures and options markets that were always closely linked to the equity markets or in markets for other types of products. The example given by the equity cash markets may be summarised as follows: electronics, remote membership, open architecture, transparent price formation process and pre-and post-trading and finally a perfect audit trail.
FESE
Traditionally, the Federation of European Securities Exchanges consisted of the old pre-1990 club-style Stock Exchanges. In the last few years the revolutions in market structure have also led to drastic changes in the membership and mission of the Federation. The old Exchanges have modernised, while new Exchanges have joined the membership. Futures and options Exchanges added new challenges to legislators and Regulators. The same applies to the traditional commodity Exchanges. The current ISD review and the Market Abuse proposals refreshed their interest in EU regulatory developments.
The integration of markets with clearing and settlement organisations has also brought new membership to the Federation through close and intensive cooperation with EACH, the organisation that combined the central-counterparty-based clearing houses in Europe. Discussions at EU level on clearing and settlement are a clear indication that paying attention to Brussels is becoming necessary for an ever-broadening panoply of markets and market-related institutions. FESE expects to strengthen its cooperation with ECSDA, the European Central Securities Depositories Association.
The Federation mainly functions through its committees, rarely on a hierarchical scale, essentially on a functional basis, whether dealing with cash or derivative markets, commodity specialisation, clearing and settlement or legal and regulatory matters.
EU legislation: Lamfalussy's miracle? Bolkestein's FSAP!
The mission statement of the Federation shows consistency since its beginning more than 25 years ago, but now has a much strengthened focus on the European Union's regulatory activities. While retaining its function as a forum for its members to discuss common problems and, where appropriate, come up with joint solutions, the emphasis of the Federation's work has shifted in the direction of a listening and warning post in Brussels relating to regulatory developments in the internal market of the European Union. In addition, whenever opportunities arise or may be created to present the Federations' members views and interests to EU authorities, papers are drafted and statements handed out. These are addressed not only to the European Commission as the initiator of European integration, but also to the Council as well. The European Parliament, still unknown to many, is now the co-legislator for the internal market and its views have to be seen as more and more important, even decisive.
With the introduction of the euro in 1999, the Commission realised that a review of all European Union internal market legislation, especially for capital market formation, would be crucial. Commissioner Monti and his successor by Bolkestein have presented the Financial Services Action Plan with force. This vast plan encompasses measures for securities markets, for insurance and for banking, for pension funds, for accounting standards -- and all to be accomplished in a few years. The fight between the Parliament and the two other Institutions resulted in the expected compromise early this year. The Committee of Wise Men led by Baron Lamfalussy produced its report, warmly welcomed by the financial industry including our Federation, that proposed the setting up of a regulatory committee to advise the Commission. The Wise Men insisted that at the EU level only legislation in principle (framework) should be pursued and that the implementation, compliance and enforcement should be done in a coordinated fashion but at national level. This process would transfer powers to the Commission and thereby created concerns in both Council and Parliament. For the financial industry it was crucial that Lamfalussy also proposed new methods of consultation and transparency in the legislative and regulatory processes. Mechanisms set up by the Commission as well as by CESR, the Committee of European Securities Regulators, have created trust and confidence that such consultation will be possible in great transparency and be seriously implemented.
Way forward for legislation
The current status of the Financial Services Action Plan is not too good nor too bad. Not too good, because serious delays have been caused through, for instance, the Parliament's rejection of the Takeover Directive in late 2001, the inter-institutional fight about competencies, and the occasional slowness of preparations by the Commission and of decisions by the Council. In the course of 2002, it will become clear how many of the plan's ambitions may be realised before 2005. The Mid-term Review Session that Commissioner Bolkestein and Ecofin Chairman Rato held at the end of February, with an impressive array of top level representatives from the financial industry, showed that differences of opinion are not limited to government officials.
But not too bad either, as a clear consensus was established on the need to make rapid progress with a view to enhancing the structure of Europe's capital market system thereby contributing to a more balanced and higher growth path, especially if this would include substantive progress with national and EU-level pension fund arrangements. For the capital markets, the Investment Services Directive is the most important and crucial Directive as it determines whether or not a level playing field will be created. With the ISD for intermediaries and Exchanges and the Prospectus Directive for issuers, a European passport has been created or could be put in place. This could only happen in reality if national legislators and Regulators abstain from their time-honoured habit of adding complications and requirements, when writing implementing national legislation.
The level playing field is not only applicable between nationalities represented within the European Union but also towards different players, and one example perhaps is more clear than others. Thanks to technology and the ever-decreasing costs of data storage, setting up a new Exchange is not terribly expensive (although the regulatory side of it surprises time and again in its complexity). As a result alternative trading systems (ATSs) and electronic communication networks (ECNs) have joined the scene, especially in the US and to a much lesser degree in Europe. Moreover, as was usual in the UK market, internalisation (that is, bringing together supply and demand within the major banks, often against the bank's own book, and only off-loading a balance to the market, while using the market's price as guidance) is rearing its head as well. The real question for legislators and Regulators is whether allowing such internalisation would contribute to the fairness and effectiveness of the markets and to the protection of the individual investor; or whether it would create, if allowed without too many conditions, a fragmented market endangering an appropriate price formation process. At the ISD-Hearing end of April, consensus appeared to a functional approach to regulation summed up by 'same business, same rules'.
With the Prospectus Directive proposal, the Commission aims to create a passport for issuers. The non-existence of such a passport is due to national add-ons and particularities of older legislation and not to the absence of EU legislation. The fact that in about half of the EU jurisdictions it is the Exchanges that have the power to approve prospectuses and admit securities to trading (listing), while in the other half governments or Regulators have taken over such responsibilities, complicated the picture further. The Commission proposes a transfer of such powers to Regulators and seems oblivious to indications that some Regulators are quite content to leave their national situation as it is. Although a compromise is in the making as the Parliament's amendments create scope for substantive delegation, the general thrust of the Commission proposal makes for a shift in responsibilities. It remains crucial that even if prospectus approval is to be with Regulators, Exchanges must remain masters of listing and admission to trading.
The draft proposal by the Commission for a Market Abuse Directive plans to combine modernisation of the existing Insider Trading Directive with criminalisation of a number of market abuse practises. The Commission meant to cause a transfer of market inspection and supervision powers, built up over the last decades at great costs by Exchanges, towards Regulators. These proposals, modified by Parliament's amendments, may lead to a much closer cooperation between the Regulators and the supervisory departments of the Exchanges as well as a broadening of what is defined as a crime by the EU Directive.
This latter point raises the different concern of the effectiveness of the official enforcement processes. Judicial authorities supported by Regulators have in the past been mostly ineffective or unsuccessful in prosecuting securities crime such as insider trading. There are no indications, rather to the contrary, that such authorities will be more successful with the infinitely more complex issues of market abuse. The transfer of such definitions from self-regulatory to the criminal law books may effectively prevent Exchanges and SROs from enforcing compliance with their more flexible rules in a far more efficient and faster process. It is to be hoped that the changes proposed by the European Parliament, and also the later national implementation, can take care of such concerns. It is in the interest of all investors and listed companies that capital markets are fair and honest. For Exchanges this is crucial, as confidence attracts business.
Here too, the question must be raised whether the EU legislative authorities have a sufficient grasp of what the right grid of responsibilities should be in the securities and capital markets, generally between self-regulatory practices under supervision and the action radius and effectiveness of official and judicial authorities. This is especially important because the Directives mentioned here are only a small selection. Think of Takeovers or post-Enron regulation as only two further important areas.
Trans-Atlantic capital market?
The integration of capital markets doesn't stop at the EU's borders. As they will have to comply with that part of the acquis communitaire in any case as soon as they accede to membership, many accession countries have decided to introduce EU legislation, sometimes even before EU member states do so themselves. The Federation of European Securities Exchanges has opened its doors to associate membership for Exchanges from these countries, after a thorough examination process.
But integration goes further, especially across the Northern Atlantic. In some European markets, American shares have been traded for years in relatively small volumes. A rapidly growing number of blue-chip European companies is listed and often actively traded on the New York and Nasdaq Exchanges. Discussions are going on with the United States Securities and Exchange Commission and the Commodities Futures Trading Commission to enhance the mutual opening of markets so as to allow American investors, via their intermediaries in the US, to trade directly on Europe's electronic markets and in the -- so far -- rare case of an American electronic market, to allow such a market access to Europe as well.
The positive steps taken by the CFTC a few years ago to allow Liffe, Matif and Eurex to set up screens and the new management of the SEC provide confidence such further enhancement would be possible. The re-establishment of the International Accounting Standards Board in London may well deliver soon the necessary agreement on internationally acceptable accounting standards, as it seems to be generally acknowledged that no single jurisdiction can claim the ultimate perfection in its national standards. The proposal by the European Commission for a regulation on the application of such international standards to all European listed companies is making solid progress in the European Parliament and the Ecofin Council. The implementation of that regulation by the markets with effect from 2005 is very close.
Boring or clearing?
The back-office process of the financial community used to be viewed as a backwater for failed book-keepers. In reality, the audit trail, the clearing and the settlement processes as well as custody take prime place today and rightly so! Without going into detail, these processes are fundamental to investor confidence, crucial for risk policy and now also open to competitive forces. Suggestions abound for imposed European solutions -- possible by Treaty only -- as well as for commercially or strategically driven cross-border solutions by the markets themselves. Lamfalussy made similar suggestions. Within European jurisdictions, most clearing and settlement is functioning well and effectively although many gains remain to be made, for example. by more frequent use of central counterparty clearing and cross-product margining.
The real challenges lie in the area of cross-border services within the euro and the EU area, for all financial services but especially for back offices. Inter-connectiveness of systems will be crucial as well as non-discriminatory access. Here too, service providers will only be eager to welcome more clients.
Future
The interconnectedness of all markets that trade financial products disregards many geographical and legislative borders. It is growing rapidly, resulting among other things in a relative convergence of market structures and rules. Speculation as well as academic consideration is in abundant supply about the future of securities Exchanges. Predicting the future remains difficult, but a consistent example is being given by Dr Ruben Lee, Managing Director of the Oxford Finance Group in his paper for Brookings, 'The Future of European Exchanges'. The wilder predictions come among others from Patrick Young, who predicts a rapid and drastic consolidation shortly to happen. It is to be hoped that current and new EU legislation will take into account the variety and flexibility that financial markets need to flourish and to serve their ultimate goal: an efficiently functioning and growing economy.
Notes
[1] See Dr Benn Steil in 'Changes in the Ownership and Governance of Securities Exchanges: Causes and Consequences' -- also available at www.fese.be/economicsreports.htm.
[2] See www.fese.be/speeches/ceps_london_8_february_2002.htm for more detailed commentary on this matter.
