What if the upturn doesn’t turn up?
appetite for equities continues to be weak. But isn’t that a reflection of
macro-economic uncertainties rather than market structure problems?
Of course the poor economic outlook for developed markets is
a major factor. However, the equity markets haven’t helped themselves over the
past few years. When demand is so constrained, measures that could reassure
investors should at least be considered.
Besides, we know market structure issues can have a significant
impact on equity market activity. After the US flash crash of 6 May 2010, US$25
billion was immediately withdrawn from the equity markets by US mutual funds
and it took more than six months for flows to turn positive again.
Today there’s no one single issue to blame but the outlook
is undeniably bleak. In May, global equities benchmarks recorded their worst
performance since September 2011, with the FTSE All World index sliding 9%
during the month. While most of the declines took place in euro-zone countries
such as Italy and Spain, the US’s S&P 500 fell 6.3% in May, but remains 4.2%
over the year. As we know, sliding prices tend to depress volumes which in turn
increases trading costs, through higher volatility and market impact.
For the third year in a row, commission payments from US
institutional investors to their domestic equities brokers declined, according
to Greenwich Associates. They now stand at their lowest level (US$10.86
billion) since 2007, and there’s little prospect of a resurgence: a quarter of firms interviewed by Greenwich
said they planned to reduce active domestic allocations by 2014.
But surely a few
success stories for equity market investors are more likely to prompt a
turnaround in sentiment than tinkering with the rules?
The last few months have supplied ample evidence that market
structure can hamper the chances of investors realising the kind of returns
that breed confidence and stimulate volumes. The equity markets have been
starved of new blood in recent years but already in 2012 two high profile US
IPOs – BATS Global Markets and Facebook – have damaged investor confidence
rather than boosted it. In both cases, the highly automated trading
infrastructures on which equity markets now run failed to execute a transparent
and efficient auction process. And for Facebook the technology glitches were
compounded by accusations that downward revisions of revenue forecasts were
accessible only to a privileged few. Having touched US$45 per share on debut, Facebook’s
decline to US27.72 last Friday has been accompanied by discussions about the
conflicts of interest inherent in an investment banking model that allows IPO
lead managers to also serve as research providers on the stocks they underwrite.
While one can blame the economic situation for the lack of
IPOs – 81 firms went public in the US last year, compared with an average of
311 between 1980 and 2000 – there is no guarantee of a listings explosion when developed
economies show signs of sustainable growth. Private equity firms are now as
likely to check out of their start-up investments through trade sales, while
partnerships and family firms are proving perfectly able to expand without taking
the traditional route to wider share ownership. If IPOs cannot be conducted competently,
the equity markets are likely to continue to struggle to generate investor interest.
OK, so what kinds of market
structure reforms are most likely to support investor confidence in the equity
One barrier to improving investor confidence is that market
observers seem hopelessly divided on causes of weakness in market structure.
For every academically rigorous report on the malign influence of
high-frequency trading, another will inevitably emerge – replete with charts
and data points – proving the benefits of low-latency arbitrage beyond
Another is problem is that two factors that tend to
encourage investors – low trading costs and transparency – are so often set
against each other. For example, will central clearing of OTC derivatives
reduce volumes through greater post-trade costs or create greater trading
activity, by bring new entrants into a more transparent and safer post reform
If one accepts that western democracy’s recovery from the
global financial crisis will be marked by further crackdowns on market practices
perceived “too risky” by politicians and regulators, the prospects for improved
investor confidence should perhaps be measured in terms of the impact of wider
reform packages – whether by design or unintended consequence.
And then there’s the reform process itself. While the
Volcker rule in the US and the proposals from the UK’s Independent Commission
on Banking have support in principle, special pleadings and exemptions may
leave investors as uncertain as ever.
here to vote in this month’s poll.