Kay: Jury out on innovation’s benefit to markets

A new report from the UK government raises doubts that recent changes in market structure have yielded sufficient advantages to market participants.

A new report from the UK government raises doubts that recent changes in market structure have yielded sufficient advantages to market participants.

According to Professor John Kay – commissioned by the Department for Business, Innovation and Skills (BIS) to review Britain’s equity markets – the jury is out over just how beneficial a range of perceived improvements to market structure have been. Increased venue competition, fragmented liquidity, greater transparency and electronic trading have all generated obstacles as well as rewards to the buy-side.

While transparency is commonly touted as essential to competitive pricing, Kay said in his interim report there was a technical argument over the degree of transparency which contributes most to the efficiency of trading.

“[This is] an argument which has gained salience as a result of the creation of so-called ‘dark pools’ of liquidity,” Kay’s report read, conceding a growing trend towards trading in the dark.

More than 80 individuals and organisations responded to Kay’s request for submissions to the review, and he said “it would be difficult to read the responses…without acquiring some scepticism as to whether the beliefs that more information is always better, that greater transparency is desirable, that more disclosure is beneficial, are always well founded”.

Issues raised concerning the dissemination and sharing of information included receiving useless or misleading information. Market participants also told Kay they often were required to act, or felt under pressure or obligation to act, on information even though they did not believe doing so was in the best interests of those they represent.

Competition good for whom? 

Increased competition among trading venues also came under fire from the review. While in the UK the dominance of the London Stock Exchange has been challenged by the likes of multilateral trading facilities such as BATS Chi-X Europe and various other new venues, Kay said some market participants were sceptical about the advantages of such competition.

“They expressed the regret that the older model – in which the exchange was a utility, existing to serve the needs of market participants in the first instance and then the economy more generally – had been displaced by one in which exchange services were a standalone business,” the report read.

British insurer Royal London told Kay it believed “exchanges have shifted to being commercial activities rather than being organisations owned by users so the incentives have changed and finding ways of encouraging and facilitating greater trading is seen as an end in itself”.

Fund manager Hermes said its belief was that “the regulatory framework for the markets and the structure of those markets has increasingly moved to favour liquidity and trading activity over long term ownership”.

Highly frequent berating 

High frequency trading (HFT) once more came under the microscope in the government report, with many respondents to Kay’s review critical of the practice.

“Supporters of high frequency trading claim that it increases liquidity and reduces price volatility. They point to the very low spreads now quoted on many popular stocks,” read the report. “The majority of our respondents were sceptical of these claims. They asserted that overall volatility had not been reduced, and doubted that the liquidity which high frequency trading claimed to provide was real.”

A response on behalf of fund manager Aviva said: “While some argue that spreads have reduced as a result of this activity, in reality the extent and depth of liquidity they really represent is questionable”.

Short shrift 

With short selling receiving considerable negative publicity, Kay said some respondents believed the practice inhibited a company’s long-term decision making.

“They cited ‘bear raids’, in which short sellers acting in concert drive down the value of a stock and create or aggravate the corporate problem from which they seek to profit,” said the report, admitting other respondents argued short sellers may often have a more informed and longer term view of the business of a company than analysts who have an interest in promoting stocks in the hope of gaining corporate business.

UK business secretary Vince Cable, a Liberal Democrat who commissioned the report, said the Kay’s findings highlighted the need for a radical overhaul of the country’s equity market structure.

The TRADE’s sister publication, aiCIO, has reported that investors are being bombarded with information from listed companies, which is forcing them to make short-term, misguided decisions. Read more here.

Kay's final report is due out in the summer.