WHOSE MARKET IS IT ANYWAY?
Richard Balarkas, President and CEO, Instinet Europe.
As many people will know, I am quite capable of talking ad nauseam on the subject of best execution and the essential role that unbundling plays for the discerning purchaser of execution and other broker-supplied services. But like many of a similar disposition I have taken to referring less and less to that sacred tome on the subject, the so-called “Myners Report”, which was issued in 2001. Let’s face it, eleven years is a long time given today’s rapidly evolving market structure, and its yellowing, dog-eared pages were effectively consigned to the archive box in 2008 when the FSA more or less shrugged its collective shoulders and muttered “case closed” on the subject of unbundling.
But fear not, for there is a new beacon carrier — John Kay, professor, FT columnist and writer of books with titles like The Long and the Short of It: Finance and Investment for Normally Intelligent People Who are Not in the Industry and Obliquity: Why Our Goals are Best Achieved Indirectly (the latter title I particularly warm to, having resorted on many occasions – unsuccessfully – to explaining my own apparent inaction using similar theories). John Kay is currently charged with undertaking a study on behalf of the UK Business Secretary on the role of the equity markets, and to that end he has issued an interim report.
I suspect the last thing John Kay wants is to be perceived as a “beacon carrier”, but for me it’s too late as in his interim report he has revealed himself as a fellow troublemaker by questioning much of the assumed wisdom surrounding the purpose and nature of the equity markets. He has also revived a number of topics that Myners highlighted, such as the “tyranny” of benchmarking and the value of intermediaries for starters. If he carries on like this his final report may warrant the title: Finance and Investment for Normally Intelligent People Who Are in the Industry”. Based on my recent experience listening to senior industry executives and other worthies pontificating on the equity markets, this ought to go straight to the top of the best-seller list.
In much the same way that the Myners Report went to the roots of the fund management industry’s issues by exposing, among other things, the structural failings that led to sub-optimal competition, rampant over-supply and unmanaged consumption of third-party research, John Kay is not afraid to go back to first principles. For example, in his interim report he explores the different potential meanings of “share ownership”, and doesn’t shy from challenging the Investment Management Association’s assertion that all asset managers are investors. He unpicks the terms “long“ and “short”, highlighting their very different applications and relevance. He even describes as “naïve” the view that short-term investment horizons drive short-term horizons in the businesses in which they invest. This is punchy stuff, as the accepted problem of short term-ism amongst institutional shareholders was one that the Myners report, and many preceding it, set out to address.
All very interesting, but are they relevant to the subject of trading and best execution? Not in the least. Whereas in recent years Paul Myners has questioned the validity of high frequency trading on the basis that it is difficult to reconcile a few nanoseconds of share ownership with the concept of joint stock holding and corporate governance, the Kay Report recognises there may be different types of shareholder, some of whom are not investors in the traditional sense and some of whom should be distanced from issues of corporate governance and voting rights. The interim report describes as a “fallacy” the view that savers who buy shares in a company are providers of capital to the company, since the funds savers put into the equity market generally go to the previous shareholder. A possible conclusion therefore is not to let the debate about market structure and the rights and wrongs of HFT be distorted by outmoded views about joint stock ownership and corporate governance.
If all the Kay Report ultimately does is dispense with the myths, fallacies and starting point biases that permeate discussions about the equity markets, it will have achieved a worthy goal. In my opinion, unless and until there is a sensible agreement as to the purpose of the equity markets there can be no sensible conclusion to the increasingly heated debates that take place about equity market structure. These debates, focusing on exchange competition, fragmentation, dark liquidity and the role of electronic and algorithmic trading, have increasingly shifted from the discipline of science to the postulations of metaphysics. There are some moves to counter this trend. For example, the UK Government Office for Science has set up a project to look at the long-term impact of computerised trading, and in the US the Commodity Futures Trading Commission has assembled a panel to look at high frequency trading. These are sensible moves, but hardly effective as a counterbalance to the emotion that dominates current thinking.
It should please John Kay that the equity markets have undergone a process of democratisation over the last twenty years through which the role of trading intermediary has been radically altered, with privileged monopolies displaced through the introduction of competition. In fact, one could argue that the prevalence of high frequency traders epitomises this process of democratisation, as does the more competitive market structure that exists today. That view, however, does not appear to be shared by many who have responded to Mr. Kay. The opinions he has garnered include much criticism of fragmented markets, dark pools, DMA and algorithmic trading and high frequency trading in general.
To many, the Stock Exchange model of 20 years ago is recalled as a halcyon era, where there was a single marketplace with full transparency populated by a fine body of men (mainly) whose word was their bond. Throw away the rose-tinted glasses, though, and this might be looked at a different way. All bargains had to be conducted face-to-face on the floor of a single exchange with the market makers in the stock. The price of every stock was determined by an oligopoly, who received significant financial privileges for their commitments to trade, and who could not be excluded from a trade. This whole arrangement served to levy what might be called it a “low-frequency tax” on every investor.
Because all trades took place in the same building, “fragmentation” had not entered the lexicon of market structure parlance, but that didn’t mean it was non-existent. In effect, each market maker was a separate pool of liquidity, and a dark pool at that. Each jobber’s book was the equivalent of an inefficiently run MTF with a minimum visible bid and offer size, behind which was a dark pool that may or may not have had any liquidity. Only in this case, each of these MTFs was run exclusively by a single prop trading firm with an informational advantage. Getting business done without causing price impact was more of a skill then than it is now, with brokers acting on behalf of investors moving around the floor in full gaze of their adversaries, each of whom had to be confronted face-to-face to strike a bargain. In short, the suggestion that the markets of yesteryear were more efficient than today’s is pure fiction.
I hope that John Kay might in due course highlight some fallacies that emerge from what I refer to as “Behavioural Regulation” (I may have invented this term but he will know what I mean). Like behavioural finance, clearly many regulatory pronouncements are not entirely rational, being instead influenced by emotions, the media, internal biases and political expediency.
Take the “flash crash” and the unquestioning acceptance of the headlines that followed, such as: “Flash Crash Wipes $1 Trillion Off the Value of US Companies”. Worldwide outrage that Corporate America was wiped out led to regulators in all regions sharpening their pencils to “stop it from happening here”. But does the headline have any real meaning? That an extremely small number of shares changed hands at ludicrous prices does not mean companies like Accenture were really worth a fraction of their real value. It is really nonsensical to believe that a small number of trades taking place at oddball prices could imply the US market can be bought at a trillion dollar discount. The subsequent regulatory focus should not be driven by an emotional response to headlines about financial Armageddon, but should focus on smaller, simpler matters like: Why did anyone exercising even a semblance of fiduciary duty sell 100 shares at 1 cent? Why was a trader permitted to post a bid for 100 shares at 1 cent in the first place? As John Kay is already questioning the validity of indices for portfolio construction, he could also highlight the weak connection between the value of a company and its share price.
Importantly, John Kay’s interim report states the simple truth that the economic performance of listed companies should result in an equal economic return to investors, less the costs of intermediation. The market does not exist for intermediaries, and intermediaries must demonstrate they add value, and by intermediaries he includes both brokers and wealth managers. The growth of institutionalisation and intermediation in the UK equity markets is a relatively recent event, replacing a construct in which private investors had a much more direct, and often more long-term, relationship with the listed company.
In this context it is interesting to consider who should have the upper hand when it comes to designing market structure. One might be forgiven for thinking that the institutional equity trader is the key participant for whom the market should be designed, and for whom the perennial problem is that of finding sufficient liquidity. Increasingly fragmented and fast markets may be troubling to such participants whose order sizes are huge compared to the displayed bid and offer. Their ideal, however, of a pure dark pool overflowing with non-toxic liquidity in which to match block trades may not necessarily pass professor Kay’s test of what is good for the market as a whole. After all they are just one class of intermediary, and their problem only arises as a result of their very existence and success.
Indeed the lexicon of market structure jargon to which we have become accustomed – RIEs, MTFs, BCNs, OTFs, the whole arcane metaphysics of MiFID, etc. – is the result of years of lobbying by the whole gamut of intermediaries on the one hand (brokers, exchanges, clearers, asset managers, prop traders etc) and regulators trying to influence (if not out-game) them on the other. Can anyone imagine an end investor or a corporation looking to issue equity ever dreaming up concepts like “pre-trade transparency waivers” or getting in such a tangle attempting to define the secondary markets on which to trade shares.
The clarity with which John Kay’s interim report sets out the basic principles of the equity markets contrasts starkly with the increasingly politicised debate surrounding MiFID 2 (which many professionals are finding increasingly difficult to follow and understand). The markets may not exist to serve intermediaries, but nor do they exist as a tool through which frustrated politicians can indirectly exert punishment on the financial sector. It may be too much to hope that a UK government sponsored report may hold any sway in Europe, but it comes as a timely reminder to all concerned that equity market structure is not a playground for the sell side, the primary preserve of institutional investors, or a tool to inflict misguided revenge for the financial crisis. Whose market is it, anyway?©BestExecution | 2012