The year 2001-02 saw different preoccupations on either side of the Atlantic in high level public policy towards the stock exchange and securities industry. While there was a flurry of controversial initiatives in Europe, on the American side, after all the controversies, changes and excitement of 2000, there was a sense of anti-climax.
There was nothing on the agenda comparable to the decimalisation of share prices or the introduction of Regulation FD, which requires companies to disclose all market-sensitive information publicly, thereby ending their discreet briefings of stockbroking analysts. Nor was there anything on the litigation horizon comparable to the surge of lawsuits against the over-optimistic analysts of Internet (and other) stocks, accused of being in the pocket of their corporate finance colleagues. Most of the heat generated by the collapse of the energy giant Enron, for example, is being felt by the accountancy profession rather than by the securities industry.
In the absence of anything more dramatic, those involved in the trading of securities, its regulation and the supporting market data business looked forward to the report of the committee on market data headed by Professor Joel Seligman, the Dean of Washington University School of Law.
Unfortunately, the report was delivered -- in accordance with its mandate -- just three days after the September 11 attacks on New York and Washington DC and little has so far been implemented. However, the report is worthy of closer examination because of the breadth of the committee's membership and the breadth of its work in producing the first official review of the provision of market data since the central market system was created in 1975.
The key recommendation of the report is to introduce more competition into the provision of stock market data. As Seligman said in his introduction to the report: "The Advisory Committee Report is most significant in its recommendation of a new, more competitive structure for market information consolidation and a less regulatory approach to this aspect of the National Market System."
It would do so by ending the current reliance on a single consolidator, the Consolidated Tape Association or CTA. It would allow competing consolidators to bring together prices and trades from different stock exchanges, Electronic Computing Networks (ECNs) and Alternative Trading Systems (ATSs) and display them on a unified basis. The report suggests that a system of competing consolidators is feasible technologically and that the risks are manageable. The main risk is that of creating a false market as a result of a technological failing at particular consolidator. Messages and orders would then get out of sequence and different consolidators would end up showing different prices.
A dissenting minority on the committee felt that the existing system of consolidation works efficiently, reliably and cheaply and that changing it would be a distraction from the other more pressing issues affecting the industry. However, the majority of the committee concluded that the economic benefits of competition and innovation in data consolidation would outweigh the costs and risks of monopoly pricing and reduced efficiency. "Monopoly systems soon accumulate dust," one insider said.
The 25-member committee was set up in mid-2000 at the behest of the Securities and Exchange Commission (SEC), which had already set in motion a debate on the key issues. Its own 'concept release' discussed the fee levels for, and profitability of, market data. The SEC in turn had been spurred into action by a complaint about market data fees by Charles Schwab, a leading retail stockbroker, directed primarily against the New York Stock Exchange (NYSE). At present, charges for the consolidated tape service -- which was introduced as part of the National Market System -- and the National Best Bid and Offer (NBBO) requirements are levied on a cost-plus basis. A related development that influenced the formation of the committee was that the NYSE wanted -- and still wants -- SEC permission to withdraw from the Consolidated Tape Association.
Underlying all these concerns have been the huge advances in information and communications technology, in particular the use of the Internet as a means of distribution, which many believe makes the 1975 system anachronistic. If exchanges can compete with each other and with ECNs as marketplaces for trading shares then, the reformers felt, the providers and consolidators of the market data generated by that trading process should also be able to compete with each other.
The SEC's inclination was not to change the rules. Its best execution obligations on brokers and the fiduciary obligations on exchanges and market centres ensured a consolidated data business. But the SEC also recognised that its primary interest and specialisation has always been in market structure, not market data, and it felt that it was getting out of its depth. That is why it turned to Seligman and his committee.
Some of its members felt that the committee interpreted its brief too broadly. According to one of the critics: "The members were high powered managers of trading operations and exchanges, meeting once every two months. Everybody sat in a big room around the table. The questions were keyed in by Seligman with comments going around the room. We discussed things like market data's role in transparency. It was very broad. We had complete flexibility to look at systems and structure. As a result, it was a mile wide and an inch deep and so a bit of a waste of time. The committee itself did not have a chance to go very deep into those issues."
Linked to the committee's recommendation to introduce competing consolidators was its support for retaining the 'Display' rule. This requires vendors and broker-dealers to provide a consolidated display of last sale transaction reports and quotations from all exchanges and other trading centres.
The Seligman committee proposal with the most immediate practical impact was on a different issue. The committee proposed that the exchanges and trading centres should be free to generate and provide additional non-mandatory, non-core data -- outside the consolidated stream -- and charge whatever price they wish for it on a customised basis. Such data might comprise details of limit orders, in particular the depth of the limit order book. Since the Seligman report was published, both NYSE and Nasdaq have started offering such products.
But apart from this, no action has been taken since September to implement any of the report's recommendations. Nor is there any short-term prospect of that happening.
A similar conclusion could be drawn about other proposals to reform US regulation. The pressures to rationalise the fragmented and muddled patchwork of regulators responsible for the US securities markets faded away during 2001. Little was heard about the SEC's long-standing ambition to take over or merge with the Commodities and Futures Trading Commission. More surprisingly, in view of the intensifying trends elsewhere in the world, there was virtually no sign of pressure on the securities exchanges, in particular the NYSE, and no initiative from within to make the kind of structural changes that SEC would have liked, i.e. for the exchanges to demutualise, perhaps to become public quoted companies, and as a natural corollary to shed most of their regulatory responsibilities.
The inertia in the US was partly the result of a hiatus at the top of the SEC. A new SEC chairman, Harvey Pitt, replaced the more activist Arthur Levitt who was linked with the outgoing Clinton administration. Also for most of 2001, a majority of the five commissioner seats on the SEC were left unfilled, or filled only on a temporary basis.
The other causes for the inertia were external events, which radically reordered the list of priorities, in particular the September 11 attacks and the collapse of Enron.
Joel Seligman himself spent more of his time in the early months of 2002 before Congress and the press discussing the regulation of the accountancy profession, as part of the Enron fall-out, than on debates about his market data consolidation proposals.
On the Eastern side of the ocean, the moves to reform the regulation of the European Union securities markets proceeded at what entrenched interests considered an alarmingly rapid pace. Certainly, in comparison with the traditional glacial pace of pan-EU integration and reform and with the inertia in the US, the initiatives emanating from Brussels, London and other European financial centres came fast and thick.
At the institutional level, the key development was the creation last autumn of the Committee of European Securities Regulators (CESR, already known familiarly as 'Caesar') as part of a new streamlined process for introducing new legislation and regulations. These were the recommendations of last year's report on the regulation of Europe's securities markets by the group of 'wise men', under Baron Alexandre Lamfalussy, who were examining why the 1996 investment services directive was failing to achieve an integrated pan-European securities market.
CESR has taken over the role of coordinating securities regulators and legislation across Europe from the Federation of European Securities Commissions (Fesco). But its main job is introducing the detailed rules necessary to implement those principles of the European Union Investment Services Directive that affect the securities markets.
The launch of CESR raised hopes in some that it may be the precursor of a European Union SEC. But both CESR and Lamfalussy have focused on achieving more mundane objectives.
So far CESR has published consultative papers on four issues. The most important and controversial of these was the market abuse directive, which is targeted against insider dealing and market manipulation. The controversy arose from the lack of consultation with the securities industry before the draft directive was published last June, in spite of Lamfalussy's emphasis on the need for just such consultation. Critics claimed that the breadth of its attack, the range of its targets, its provisions for prosecuting a market 'abuser' even if he had no wrongful intentions and the obvious drafting oversights stemmed from the lack of industry input. It would turn into criminals, they said, stockbroking analysts who were merely doing their job by probing company accounts and financial journalists who made an honest mistake.
The response of CESR was that more qualifications and defences would appear in the detailed rules once the directive is passed. The other equally important principle in the market abuse directive, which has attracted far less criticism, is that poachers cannot be gamekeepers and that stock exchanges, as they demutualise and become 'normal' commercial organisations, must be viewed as being in the poachers' camp. For that reason, an independent supervisory agency to curb market abuse is essential.
The other controversial regulation was on prospectuses, which was also rushed through the draft stages with inadequate consultation in 2001. However, the passage through the European Parliament in March 2002 permitted the introduction of a far-reaching exemption from the provisions for all companies with a market capitalisation of less than EUR350m. As a result small companies, particularly those with quotations on junior markets, will not be required to issue prospectuses when raising capital or seeking a quotation. The notion that larger companies should be able to issue a prospectus with validity across Europe is almost universally supported.
In October 2001, CESR published a paper on the conduct of business rules for the protection of investors, a longstanding item on the Fesco agenda, and a paper on the definition of different categories of investor. The main issue in the conduct of business rules is the establishment of the right of firms to conduct business across the entire EU while being supervised only in their home country. For exchanges, that means entrenching their rights to list securities from all EU markets.
In January 2002, CESR published revised proposals for common European standards for Alternative Trading Systems defined as venues for multilateral trading between multiple buying and selling interests. ATSs are transforming the European landscape in the same way as so-called ECNs (Electronic Computing Networks) did in the US in the late 1990s.
The paper was prepared by an expert group chaired by Howard Davies, Chairman of the UK Financial Services Authority. Among its aims are the creation of a level playing field between ATSs and exchanges, on issues such as the 'printing' (publication) of transactions and price transparency, and more importantly the preservation of the integrity of the market when trading is fragmented across many different venues.
These are some of the issues concerning price transparency that the EU is now considering, several of which also fell within the remit of the Seligman committee in the US:
- Should there be a consolidated tape of stock market prices across Europe?
- How should the regulators define and enforce a common standard of price transparency given the large discrepancies at present?
- Should the transparency rules that apply to equities -- the most important class of securities because of the strong information content of equity trades -- also apply to bonds, swaps and financial derivatives?
- Should there even be rules for commodity derivatives and foreign exchange?
- Should transactions from the internalised trading within investment banks be printed, and printed immediately?
- Should delays be granted in the printing of large 'risk' trades, i.e. where the broker-dealer has taken on the principal risk himself to facilitate a transaction with his client? (On this issue, the EU has taken a much more hawkish stance than the UK which has traditionally relied on market-makers to act as principals in facilitating large trades with institutions.)
- Should there be a requirement for all trades in a particular security to be reported back, for consolidation purposes, to the lead exchange, i.e. the stock exchange or trading venue where most of the trading takes place?
- Should retail orders be required to interact on the lead exchange, as is required in some EU countries?
- Should the authorities intervene to establish and entrench competition in the provision of regulatory news (as happened in 2002 in the UK) and of consolidated market data?
The bigger issue, which is common to regulators across the globe, is how transparency should be related to the principles of best execution (of transactions by brokers for clients). The proliferation of trading venues -- stock exchanges, ATSs, ECNs, over-the-counter dealers and internalised trading within large investment banks -- has made finding the best price more complex. For large institutional deals, which have accounted for a growing proportion of the market in both the US and Europe for more than 30 years, there is a further set of trade-offs between immediacy, price, size and certainty of execution.
Regulators have come under some pressure from compliance officers within securities firms and investment banks to be prescriptive, to define best execution or at least to create a safe harbour for transactions that cannot be challenged.
One example of such an approach in the UK is that of the retail service providers (RSPs), who transact small bargains for private clients and typically agree, as a matter of contract, to give at least the best price available on 'Sets' -- the London Stock Exchange's limit order book. But for larger bargains, where immediate execution would force the market price against the dealer, there are few proposals, let alone any consensus, as to how a safe harbour might be defined.
In London, investment banks typically ask their institutional clients if they are prepared to waive the best execution requirements. Less than 10% agree, which suggests that the principle, however vague, still offers some degree of protection even for professional investors.
And, apart from the difficulties of definition, regulators have also become wary of specifying detailed rules as inevitably such rules create loopholes and allow brokers off the hook in circumstances where they failed to perform adequately.
A more useful approach may be, as with fund managers, to require brokers, and particularly those dealing with retail customers who have little means of judging, to publish performance figures. In the UK, for example, RSPs could be required to publish what proportion of bargains they transact for clients within the Sets spread -- and what the average price improvement is. At present, in virtually all countries, private investors have to compare execution-only brokers primarily on their commission charges (and back office reliability) whereas, in hard monetary terms, price improvements are generally much more important.
In fact the limited evidence available, mainly from the UK, suggests that brokers have been achieving more consistent standards when dealing for clients. Indeed, five years ago in the UK the regulator monitored transactions data and wrote to firms that dealt at prices that were clearly out of line. But such monitoring was discontinued as the amount of poor practice it unearthed diminished.
Overall the increasing influence of the UK on European securities regulation -- and on the regulation of other financial services -- has been highlighted by these proposals and developments. The principles of the common law and of the Anglo-Saxon emphasis on transparency, disclosure and informed consent have gradually been ousting the widespread continental European emphasis on detailed prescriptive rules and price controls.
Within the UK itself another trend-setting development took place, which has already had a profound effect across Europe. In December 2001, the single unified Financial Services Authority took over formal responsibility for the regulation of nearly all the securities industry, as well as most other financial services, including mutual funds, insurance and pensions. Previously, since the Financial Services Act of 1986, regulatory responsibility had been divided between a variety, albeit a diminishing number, of industry or profession-specific self-regulatory organisations.
The overhaul of the UK regulatory regime had been in preparation for more than four years, and had already influenced other European countries. Sweden, Ireland, the Netherlands and Australia have all followed suit and created a similar unified regulator for all financial services. If the German federal government too is able to impose its vision of a single regulator on the individual states, then among the larger OECD countries, a separate regulator for the securities industry and for the banks will continue to exist only in France and Italy.
And of course, amid a confusion of other federal and state institutions, in the US.
