Sense of urgency underpins fresh scrutiny of markets

By Nicole Bullock. This article originally appeared on the Financial Times website, on September 16th, 2014

For the past five years, global policy makers have sought, with varying degrees of success, to reform the over-the-counter derivatives market that they believed had exacerbated the events of 2008.

Their aim was to make the opaque $700tn swaps market more transparent, turning it from something that was largely bilateral and telephone-based into an anonymous, electronic market.

Yet, in that same period, some argue trading equities in the US, and to a lesser extent Europe, has been steadily becoming less transparent.

Regulation finalised a decade ago introduced competition and trading volumes have leaked away from traditional exchanges to rivals or alternative trading venues and so-called dark pools – often run by banks – all of which match buyers and sellers directly.

Digitisation encouraged more automatic trading by computers and the speed of deals was soon measured in milliseconds.

Investors may have had a competitive price for their trades but markets, whose cornerstones have been accessibility and transparency of information, could not always easily explain sudden share movements or runs.

This debate has dominated talk in the “structure industry”, an all-encompassing term for the operators of the world’s markets’ “plumbing” and the users charged with understanding it to obtain the best deal for their clients.

Even so, few were prepared for the reaction when Michael Lewis, one of America’s best-known chroniclers of financial markets, turned his attention to this world in his latest book, Flash Boys , published this year.

Mr Lewis depicted a world of high-frequency trading featuring large investment funds that were unaware of the revolution taking place around them. Critics said that Mr Lewis’s book was incomplete and one-sided but nevertheless, it shot to the top of the reading charts and brought the issues to a wider audience. Coincidence or not, within three months, the SEC had started an in-depth review of market structure and Eric Schneiderman, the New York Attorney General, had launched a suit against Barclays, alleging it had misled investors about the level of high-frequency trading activity in its dark pool, an allegation that Barclays has rejected. More banks have since been drawn into the investigation.

Given the role that regulation played in creating the situation, regulators are reviewing what sort of market they want – and how they want achieve it.

“Our regulatory changes must be informed by clear-eyed, unbiased, and fact-based assessments of the likely impacts – positive and negative – on market quality for investors and issuers,” says Mary Jo White, chairwoman of the SEC.

The regulatory review is extensive. US and UK authorities are also looking at the incentives that brokers and exchanges use to attract custom, such as payment for order flow. Yet, regulators and executives are equally aware that the more prescriptive the regulation, the less relevance it will have to the public.

Christian Katz, chairman of the Federation of European Securities Exchanges, says: “Given the challenges that Europe has on many fronts today, I believe the policy issues that we have to talk about are so complex that it is difficult to discuss them at length.”

Nevertheless, he would welcome more explicit statements on markets policy. “For the person who takes over from Michel Barnier [head of the European Commission’s markets division] . . . it’s a chance to do that. It makes it clear where we’re going, whether the public sign up to that vision,” he adds.

Others are pursuing their own paths to force change. Upon purchasing the New York Stock Exchange last November, Intercontinental­Exchange announced it would be slimming down the number of order types on the Big Board. At the other end of the scale, IEX Group – an innovative start-up that plays a major role in Mr Lewis’s account – is about to apply to become the US’s latest exchange.

The sense of urgency that now accompanies overseeing the equities market has thrown the reform of derivatives markets into sharp focus. Trading of OTC derivatives in the US – via venues known as swap execution facilities (Sefs) has begun, but few have noticed much difference as yet.

Europe is finalising its own rules, which are not due until 2017. The final step remains knitting together the legislation that offers differing interpretations of the same broad principles.

The US and Europe remain bogged down arguing about the fine details that will allow Europe to recognise overseas clearing houses as equivalent.

The discussions have been slow and sometimes tense, but the stakes are high. Market participants have warned that the global market could be broken up.

But hanging over the industry, both for exchanges and many of their users, has been a lack of volatility, which has curbed profits. Banks are being forced into making tough decisions

Exchanges have been looking for growth beyond their traditional role as centres for capital formation and trading. Some have moved into risk and balance sheet management for OTC markets via clearing and settlement services. For others, it remains a race to buy unique assets.

In the highest-profile move this year, the London Stock Exchange Group agreed to buy Frank Russell, the US index compiler, in a deal worth $2.7bn.

Combining it with its FTSE International brand will make the LSE one of the world’s largest index providers, especially in the fast-growing exchange traded funds market.

Exchanges are also eyeing Barclays’ Index, Portfolio and Risk Solutions business, which is up for sale and could fetch up to $1bn. Billions of dollars of assets in derivatives, structured products and listed funds are tied to Barclays indices, making them among the best-known benchmarks in fixed income markets.


Feeling the pain: Interdealer brokers

Perhaps no sector has felt the effect of recent changes more than interdealer brokers.

These middlemen had been beneficiaries of globalisation, as banks and large corporations speculated and hedged risks with derivatives. Interdealer brokers were able to shift illiquid over-the-counter (OTC) assets such as interest rate, commodities and foreign exchange swaps between buyers and sellers.

The job was tough – a testosterone-fuelled culture with punishing hours glued to telephones – but brought handsome rewards.

However, the global regulatory clean-up of the OTC market they inhabit has had a profound effect. Authorities have sought to make the process more transparent and electronic, cutting the need for brokers and biting into profit margins.

Interdealer brokers’ main customers, the broker-dealers, are required to deleverage their balance sheets to meet tougher capital requirements. Years of low global interest rates have curbed investor appetite for trading and market volatility, the industry’s lifeblood, has dried up.

These structural challenges have been supplemented by scandal. ICAP and RP Martin have both been fined by UK and US authorities in the investigation into rigging Libor.

All this means that tough decisions are being taken on jobs and assets and few predict the upheaval is over yet.

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