Malcolm Galloway Duncan
Stock Exchanges take a back seat
I recently read on the excellent Bloomberg network of the almost immediate and outstanding success of two recently inaugurated international alternative trading platforms (Multilateral Trading Platforms – MTPs), probably the first of many, now operating on the European equity markets. They have been set up by well known international security houses and banks, principally American, several of which have had roles as protagonists in the recent and ongoing international stockmarket turmoil which has required numerous bail-outs by national governments.
CHI-X, created more or less one year ago by Instinet, on Monday 17th November accounted for 15.7% of trading on FTSE 100 shares and Turquoise, set up by leading international banks, mainly American, accounted for 4.8% of market turnover in FTSE 100 shares on the same day in spite of its very recent inauguration – only three months ago. However the business goals of these two initial alternative trading platforms are far more ambitious and have European objectives.
Such developments have been permitted, or perhaps we should say, advocated and even encouraged by the European Authorities in Bruxelles with the approval of the MiFID directive, intent on successfully breaking through the previous monopoly status of the national exchanges in Europe.
Undoubtedly the European Stock Exchanges have unwittingly played their part in creating this, I would say, unhealthy situation by an excessive profit orientation since their fairly recent privatisation and listings. That is markets which have boasted year after year of outstanding profit margins and increases year on year averaging between maybe 30-40% but in one case achieving an increase even surpassing 150% (London Stock Exchange) from one year to the next. Results which would be the envy of any company in the productive sector.
However it is rather ironic that the banks, major stakeholders in the newly privatised stock exchange reality, now endorse European Community policy in favour of major competition within the stockmarket arena, also in view of extraordinary profit margins obtained by the Stock Exchanges’ almost monopoly status. This will thus deviate a part of such earnings to themselves, while previously they have been among the principal sustainers of such profit oriented policies and priorities. It is like, metaphorically speaking, killing the hen which laid the golden egg.
Market innovation contradicts market logic
In the opinion of the authors, this orientation in favour of market fragmentation would appear incongruous in the new market scenario which is essentially institutional. It represents a decided return to the past, that is prior to London’s Big Bang in October 1986. That is of fragmented, untransparent and largely illiquid market centres, capable of catering for private investment but totally inadequate for an increasingly institutional investment scenario.
That is entities which require stability and market width and depth. In fact the market crises of 1987 and 1989 were essentially caused by one way markets on the contemporary and independent decision of enormous institutional investors to make massive sales, convinced that the markets were about to peak. The October 1987 market debacle was essentially caused by the independent decision of eight or nine international investment institutions to execute massive sales in order to achieve notable gains on the very same day, which led to an incredible and economically unexplainable market slump. The wrongly identified culprits were thought to be the derivative markets which undoubtedly played a leading role in the market crashes in 2007 and 2008 but which, then, had not reached their present dimensions as illustrated in the attached graphs, produced on the basis of the figures of IMF’s offspring, the International Financial Stability Forum, first established in 1999, on the perception of a growing market malaise and which now produces six-monthly clinical reports on the health, or perhaps we should say ill-health, of the international financial arena, and possibly indicate opportune interventions in the hope of precluding further market upsets in the future.
Some may object that the enormous imbalances between the proportions of the global financial markets and the underlying world economies (GDPs), as illustrated in these two IMF graphs, has since been considerably redimensioned. Agreed! But without radical regulatory changes, a return to a state of such imbalances may simply be just a matter of time.
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It is worth remembering that in the course of the last 20 years or so, the markets have suffered at least 6 major market downturns, none of which were caused principally by economic upsets but by excessive market speculation and which have nonetheless had negative effects on the underlying economies which they are expected to support.
London’s Big Bang imposes change
Until the eighties and, in particular, till London’s Big Bang (October 1986), most European market centres were regional stock exchanges, mostly of a small nature, and which had a very minor role in their respective economies, that is except for the London Exchange. In fact several of them were very often accused of being nothing else but gambling dens.
London’s Big Bang and the preceding cancellation of currency restrictions by Margaret Thatcher’s government forced the continental exchanges to radically rethink their status quo following the very successful launching of the SEAQ International trading platform which was dedicated to the trading of internationally listed shares in London: very often the London market proved more liquid than the home exchanges.
As co-author, Malcolm Duncan, of the first report, commissioned by the European Commission in 1981 and completed in spring 1984, on how to achieve the integration of the European exchanges, I believe we unwittingly contributed to the radical restructuring of the London market and suggested to the European continental exchanges how to react, though, in the case of London, this important change was undoubtedly principally motivated by a need to either open up their market themselves and admit international security houses, principally American and Japanese, or have it imposed on them by ad hoc national laws. The British have always been rightly shy of legislative measures, especially in the ever and rapidly changing scenario of the security markets. The 350 odd page report prepared by the two EC consultants contained a detailed account of the secondary markets in all member exchanges and terminated with a list of recommendations which included the implementation of integrated national exchanges, heterogeneous corporate membership - as already in force in the Dutch stockmarket, concentrated trading and the development of institutional investment which, at that time, was practically limited to the British and Dutch financial communities.
Due to the predominance of Roman law principles in most European countries, there was a net preference for legislative as opposed to regulatory changes as the United Kingdom had opted for. As opposed to London, where the concentration of market demand was considered a logical necessity, continental European exchanges were notably illiquid owing to the fragmentation of trading and off market trading which varied from 50 to 80% of estimated effective global turnover.
The Italian Stock Exchange proposes an operational integration of the European Bourses
Wary of legislative market reforms more consonant with Roman law precepts, an Italian driven initiative led to the setting up of a European Stock Exchange Federation (FESE) in order to be able to vie with the domestic and European authorities and possibly emulate the anglo-saxon style exchange which was thought to assure superior market integrity. It is sufficient to quote the well known London motto – “dictum meum pactum”. In the hope of precluding a legislative based European market reform , the Federation, under the chairmanship of the Italian Exchange, undertook a project named “EUROQUOTE” whose intent is easily definable by its name. Though the project stage and the elaboration of the indispensable operational software were successfully terminated, and its effective inception only required additional capital for the effective linking up of the various national bourses, the ambitious project was nevertheless abandoned due to the shortsightedness of the Exchange chairmen, especially that of London. We are sure that, could one go back in time, on the basis of what followed and the status and present role of the London Exchange, they would probably now act in a radically different manner. In fact London has since lost its previous predominance on the European stockmarket scene and, from an influential point of view, has since been substituted by the German Exchange which now dominates the stage, at least from a regulatory standpoint.
Helmsmen changes and new trajectories
At this stage stock exchange privatisations were devised and achieved with little or no consideration of assuring an equal say in their future management by the three prevalent interest groups: the market operators, now chiefly banks, the enterprises (both listed and presently unlisted), and the investors, now principally institutional. A principle which was duly respected on the privatisation of the Stockholm Stock Exchange in 1992 and which led to its rapid national and international development and success.
In fact the principles adhered to on the privatisation of the Italian Stock Exchange in 1998 rapidly led to a dominance of a select number of major banking institutions. After two abortive efforts to merge the London Exchange with Deutsche Borse, mainly sponsored by the latter and strongly opposed by the smaller broker community in London, Paris, possibly irritated by the apparent betrayal of Deutsche Borse which had opted for the anglo-saxon Bourse after having first flirted with the French stockmarket community, successfully achieved the amalgamation of the Paris, Amsterdam and Bruxelles Exchanges, later joined also by the Lisbon, Oporto and Luxembourg market centres to form a stock exchange federation named EURONEXT. Much later this new European stockmarket reality was joined by none other than the New York Stock Exchange. A move probably motivated by the effects of the Sarbanes-Oxley law, passed in 2002, which tended, due to new and costly regulatory requirements, to dissuade further New York listings by European and Asian companies. A step which was almost simultaneously taken by NASD which merged with OMX, most probably for the very same motive. Strangely enough, the EURONEXT proposal had many similarities with the EUROQUOTE alternative which Paris had helped to exterminate.
European legislation may boomerang
The overriding priority of the new bank dominated stock exchange conglomerates appeared to be the achievement of ever greater profits as opposed to providing an indispensable service to their market economies which were now adopted even by previously communist oriented countries. Though market services attained notable improvements, there was little contemporary lowering in their cost. Appalled by developments which had not been envisaged by the European Commission when they had inaugurated the first European Financial Directive in 1996, the European Commission devised and, after lengthy study and discussion, approved MiFID (the Markets in Financial Instruments Directive) inaugurated on 1st November 2007, which, with the well meaning intent of counteracting the monopoly which the European Community Stock Exchanges had previously exploited to the full, authorised the setting up of alternative trading platforms (MTPs) by leading market protagonists. This will obviously lead to a fragmentation of market demand which is hardly auspicious in an institutional investment environment, and is also likely to lead to major market instability in moments of stress. The almost contemporary launching of volatility indices is a clear sign that market operators and exchanges are well aware of the probable consequences of such innovation. You might say that it is in fact a decided return to the past. The encyclopaedic nature of this new directive, which has also enforced notable changes in national laws and regulations, is likely to lead to frequent retouching which will easily lead, in view of the resultant additional costs, to a further reduction in the number of market participants in total antithesis to the most elementary law of market efficiency which recommends an adequate pluralism among competing market operators.
Helas! The devised remedy is probably worse than the malaise it is hoped to cure. The legislative and regulatory mania of recent years has exacerbated operational costs in a now completely electronic trading environment and led to the disappearance of practically all but the major market players who now provide everything in-house. “You say it, we do it!” The same market conglomerates in many European market centres finance the companies with either equity or short of medium loan capital, bring them to the stock exchanges, assure an ongoing market in the same securities by providing market-making services, take stakes in the same, produce research on the same companies and, at the same time, manages enormous investment, hedge and pension funds. A melange of business activities often in open conflict with one another.
Leading market operators will indeed now have yet another arm in order to influence the market according to their own established goals by the setting up of these MTPs which amount to yet a further potential conflict of interest. Furthermore there is likely to be little or no distinction between the trading of instruments of all kinds regularly listed on the exchanges and completely over-the-counter instruments which had a prominent role in the recent market debacle (See the attached graph based on IMF figures for October 2007), and which are well known for their opacity in times of market stress.
Chronic malaises require radical remedies
Recent and ongoing market upsets should cause serious reflection on the part of economic and market authorities, as recommended in a recent report prepared by the authors of the present article and which, in its executive summary form, was provocatively entitled: “There was a Stock Exchange............once upon a time”. Owing to the oligarchical structure of present day markets and the influential power of leading international market players, we doubt whether the market authorities will be capable of resolving the present muddle without the expert advice of independent professional associations and societies. Entities which are likely to advocate a radical rethink of market principles and structures and possibly recommend a decalogue similar to the following in order to re-establish stockmarkets which more closely respond to the priorities of market economies, and are no longer conditioned by short term speculative goals. We believe that the following recommendations might be included in any such decalogue for reform:- A new definition and status of the entities authorised to operate in the various sectors of the security markets, which should include the splitting up of investment and commercial banking which we fear has weakened the preference for equity capital and favoured the option of loan capital. We also advocate the creation of appropriate chinese walls; and the extension of corporate governance to stockmarket performance (prices plus liquidity);
- The creation of clearly defined and binding bank guide-lines for rational ratios between equity and loan capital resources and commitments;
- A new relation between corporations and credit-rating societies, especially with regard to the remuneration of the latter;
- MTPs restricted to trading listed securities or, better still, their total suppression. Should the former option be preferred, that also post trade data be integrated with Stock Exchange data and in real time;
- The closure of OTC markets or the limitation in time of recourse to such market segments and the creation of special trading venues within the established stock exchange structures to cater for such stock;
- A stop to internalising;
- New responsibilities and priorities for regulated stockmarkets whose top objective should be catering for market economies as opposed to a frenetic search for ever greater profits;
- The setting up of Stock Exchange Advisory Boards with a majority participation of end-users, that is enterprises, both listed and unlisted, and investor institutions and organisations;
- The creation of national and international ombudsmen linked to ONU and the creation of a worldwide watchdog under the aegis of ONU, wholly or partly financed by the world financial systems;
- The obligation to national state-owned TV networks to organise, on a continuous basis, informative programmes, above all directed to individual and private investors, in order to assure their adequate knowledge and understanding of the financial markets as well as the instruments in which they are counselled to invest.
The authors are curious to see whether this umpteenth warning of the need to tackle a situation which imperils the very foundations of market economies and what Italians would say may be the drop which makes the water spill over once again or whether, more likely, it amounts to yet another unheeded or ignored voice in the desert. Recent events and financial markets’ infrastructures and operational activities demand an urgent and radical rethink of their status quo. Time will tell but, if nothing matures, we will, at least, have the totally inadequate satisfaction of being able to say: “Well, we told you so!”
Giovanni BottazziMalcolm Galloway Duncan
Giovanni Bottazzi was a member of the management of Borsa Italiana from 1974 to 1994 and co-chairman of the Economics and Statistics Subcommittee of FESE (1988-92). He is currently lecturer in Technical Statistics at the State University in Milan. He is also a long standing member of AIAF, the Italian Association of Financial Analysts.
Malcolm Galloway Duncan, an Italian journalist, was head of international relations at Borsa Italiana from 1972 to 1994, advisor to the European Community (DGXV) 1981-84,and co-chairman of the FESE Subcommittee on Economics and Statistics 1988-1992. He too is a long standing member of AIAF.
