Point of no return

Nostalgia, it seems, is out of fashion as we reach the end of 2013. On surveying the ever-increasing complexity of today’s financial markets over the past 12 months, it might be tempting to hark back to the good old days. But this is an activity best indulged over a glass of port in front of an open fire during the festive period, rather than with a sense of expectation for the return of simpler times.

A panel session at last week’s ICI Global Trading and Market Structure Conference, held in London, suggested that both regulators and market participants had accepted complexity as inherent to today’s financial markets and moved on to look at how best to handle it. 

For many years, it was widely accepted that the optimum approach to running a stock market was to have all orders pass through a single exchange, with market-makers incentivised to provide liquidity in the event of an emergency to keep the market orderly. 

As noted by one of the speakers at the panel session ‘Automated trading and addressing operational risks in the market’, this approach essentially stopped working because it was increasingly viewed as unfair. Exchanges, particularly as they demutualised, were viewed as no longer working purely in members’ interests and were taking ever-higher transaction fees without necessarily improving the service. Separately, market-makers employed by exchanges to provide liquidity always needed incentives to offset their risk, but their spreads were too often resented by market participants – rightly or wrongly – who saw their pain translating into gains for the privileged few.

In short, “We have this market structure because of exchange monopolies and market-maker oligopoly. This competitive structure is necessarily more complex” … and more prone to glitches.

A senior buy-side trader who joined the panel at short notice was asked whether he missed the established market structure and pined for simpler days when a market-maker was guaranteed to offer a price.

“I personally prefer an auction mechanism to establish price. With buyer of last resort, price is always miles away. Those days have gone,” the trader said.

Regulators too have closed the door to a return to simplicity, although many might consider their approach to off-exchange trading something of a backward step. The new approach, it seems, is to make all parties fully aware of their responsibilities to financial system stability. From market operators to market participants and their operational partners, everyone is being held accountable.

This is being exemplified nowhere better than Hong Kong where, under the Securities and Futures Commission’s new electronic trading rules, buy-siders must vouch for their ability to understanding the trading tools they deploy in the market – while the suppliers must also attest to the competence of their clients. 

In Europe and the US there are plenty of other examples of personal liability being used to ensure market participants take their responsibilities seriously. 

Panellists, perhaps worn down by the waves of regulation that have crashed down on them in recent years, seemed resigned to the situation. But the logic of the regulatory direction was compelling in other ways. As one broker noted, high levels of service to clients should dictate that brokers take responsibility for ensuring they’re using fresh market data, for example, or switch to an alternative venue if the primary market fails.

Competition should drive efficient market practice, but we can all think of examples where it does not – in the financial markets and beyond. Last week’s panellists recognised this too, noting that the separation of competition issues from other matters of financial markets regulation left scope for inefficient practices to remain, preventing better solutions from taking root. Do we want to give regulators even more powers? Despite the overwhelming increase in scrutiny over the last five years, perhaps we do.