Securities markets worldwide have been on a roller-coaster ride for the past five years. The bursting of the Internet bubble, the collapse of Enron and the emerging demutualization of securities exchanges, especially in Europe, have brought the role of securities market regulators into sharper focus than before. Simultaneously, technology and globalization continue to pull down old market structures and create virtual ones that span continents. In the past the cost and awkwardness of clearing and settlement processes across nations restrained global competition among stock exchanges, but that situation is now changing. As cross-border settlement becomes cheaper and easier, global trading may increase and U.S. regulators will need to adapt to this new environment.
Financial experts from companies, the government and academia explored these issues at a conference organized by the Wharton Financial Institutions Center and the Brookings Institution in Washington, D.C. on January 10 and 11. Entitled “The Future of Securities Markets” the conference examined two central questions in research papers and panel discussions:
1. Will there be greater fragmentation or concentration of trading systems within and across nations?
2. Will there be more or less intermediation in the securities business?
Wharton finance professor Richard J. Herring, co-director of the Wharton Financial Institutions Center, moderated discussions at the conference, and Robert E. Litan, vice president and director of Economic Studies at Brookings, opened the proceedings.
The inaugural session – on the future of securities exchanges – featured Ruben Lee, managing director of the Oxford Finance Group, Marshall E. Blume, a finance professor at Wharton, and James L. Cochrane, senior vice president and chief economist, New York Stock Exchange. Lee predicted an emerging world with greater concentration of stock exchanges, where a few of them would dominate trading. In contrast, Blume pointed to the benefits of fragmentation of stock exchanges, adding that the resulting competition will limit concentration. (Blume’s analysis appears in greater detail below.)
Cochrane noted that the New York Stock Exchange operates on the assumption “that we are heading towards a world of global, stateless companies that can be domiciled anywhere, have no particular reason to be domiciled in any particular country, unless there’s a current tax regime or management team that wants to be in a certain spot.” He added that increasingly all large broker-dealers have two characteristics: First, the center of gravity of decision making “is somewhere out of the Atlantic, it’s not London, Zurich or New York – it’s somewhere in between.” And second, he pointed out that increasingly the large broker-dealers are subsidiaries of universal banks for whom that function is a marginal aspect of their overall business. “When they wake up in the morning, they don’t think about themselves as being broker-dealers,” he said.
Cochrane recalled that when the hedge-fund investor Long Term Capital Management blew up in 1998, it was the Federal Reserve that swung into action. He said that in the future too, the central bank will be the market’s final savior. That is important for broker-dealers and for those who regulate broker-dealers, he said. One big concern Cochrane voiced was the preparedness of the securities regulators when significant systemic disaster is next around the corner. He said securities regulators are not positioned to deal with such crises since they are not well-coordinated among themselves and also because they have different levels of powers. For example, while some regulators have the authority to issue subpoenas, others do not.
In the years to come, companies listed on exchanges in emerging markets might migrate to those in developed markets, according to World Bank economist Stijin Claessens and his co-authors. In a paper presented at the conference, Claessens and his colleagues supported their theory with some evidence in their paper. Against this backdrop of migrating companies, they felt that governments in emerging countries should not focus too much on developing their stock exchanges but rather create conditions such as enforced shareholder rights that allow corporations to issue and trade shares abroad efficiently.
Toward Fewer, Bigger Exchanges
Other conference participants agreed that fewer, bigger exchanges are inevitable. John Coffee, a law professor at Columbia University, said, “The prediction that consolidation would occur among the estimated 159 securities exchanges worldwide is only slightly more risky than predicting that the sun will rise tomorrow.” He added that the consolidation could play out in different ways: While some exchanges will merge, other national exchanges would develop cross-border affiliations, effectively creating supranational exchanges. The precursors of this movement are already evident in Europe, where the Paris, Amsterdam and Brussels exchanges have formed the Euronext network and where O.M. Gruppen, the Swedish exchange, recently made a hostile (but unsuccessful) offer to take over the London Stock Exchange.
Coffee also saw other, market-driven routes to consolidation. Successful market centers could drain liquidity from local or regional exchanges, leaving them intact but hollowed out, he argued. In another scenario, an ambitious and entrepreneurial market center might seek to expand by setting up outposts around the globe. Nasdaq’s recent strategy appears to fit this model, as it has acquired Easdaq in Europe and established multiple outposts in Asia.
Benn Steil, an economist at the Council on Foreign Relations, predicted an inexorable trend towards securities exchanges being operated as for-profit public companies with non-members owning them. In such cases, trading systems will become increasingly disintermediated. Consolidation will be driven by the need to exploit massive economies of scale and network effects in trading. Hans Stoll, a finance professor at Vanderbilt University’s Owen Graduate School of Management, agreed with Steil, but he added that demutualization will be slow to occur. Stoll noted that the New York Stock Exchange (NYSE) and other regional exchanges in the U.S. have not demutualized. In fact, Stoll observed an interesting trend towards remutualizing. For instance, many new exchanges seek ownership from either order flow-providing retail firms or from market-making firms. Many electronic communication networks (ECNs) have significant ownership by large dealer firms. The profits of these owners are in part based on the revenues they generate for the ECN.
Should Intermediaries Be Disintermediated?
Two papers presented at the conference addressed the role of intermediaries. Leslie Boni, a finance professor at the University of New Mexico, and Kent L. Womack, who teaches at the Amos Tuck School of Business at Dartmouth, questioned the credibility of analysts who work for brokerage firms, known in industry parlance as “sell-side analysts.” They pointed to inherent conflicts of interest: While on the one hand these analysts position themselves as objective analysts to investors, they also serve as savvy marketers to issuers of securities.
Boni and Womack also talked about the reality with which both analysts and investors have to contend. Corporations allow unfettered access to vital information only to analysts who stay close to the corporate party line, they noted. The small investor may not have sufficient appreciation of these subtle pressures, and may be disadvantaged. What investors may not understand at times is that a buy recommendation may not mean buy and hold may actually mean sell.
The initial public offering (IPO) market and the role of underwriters came under critical scrutiny from Jay Ritter, a professor of finance at the University of Florida’s Warrington College of Business. During the Internet bubble years of 1999-2000, he noted, an average of $78 million was left on the table. Money on the table is defined as the first-day price change (offer price to close) times the number of shares issued. Underwriters, as intermediaries, need to balance the interests of the sell side (issuers) and the buy side (investors). Ritter says that if underwriters receive compensation from both the issuer (the gross spread, or underwriting discount, typically 7% of the proceeds for moderate-size IPOs) and investors (through quid pro quos in return for leaving money on the table), the underwriter has an incentive to recommend a lower offer price than if the compensation was merely the gross spread.
Ritter made a strong case for the U.S. Securities and Exchange Commission (SEC) to start enforcing the existing rules, including those on the full disclosure of compensation received by underwriters. Underwriter compensation can be both direct and indirect. Indirect compensation is the revenue generated by rent-seeking buy-side clients. Ritter believes that if issuers saw the indirect compensation explicitly, they would be less complacent about leaving a lot of money on the table.
Taking an all-encompassing view of the ideas presented at the conference, Paul Mahoney, a law professor at the University of Virginia, said observers could construct visions of the securities markets that span quite a broad range. At one end of that range they could imagine tomorrow’s stock exchanges consisting of a small number of exchanges in major market centers “that are part E-Bay and part Bloomberg”. By this, he meant that these exchanges would offer end-users direct access to market data as well as the ability to trade directly among themselves.
At the other end of the spectrum, they might see as many exchanges as there exist today – and perhaps even more – competing on the basis of different forms of organization, serving slightly different mixes of clientele. This would be coupled perhaps with a shift in importance of different types of intermediaries, but not a dramatic move towards a disintermediation. Such a system would still be organized, and governed and largely owned by intermediaries, according to Mahoney.
The Challenges of Global Trading
Wharton professor Blume outlined the implications for regulators as stock markets become increasingly global. He called upon the SEC to give up what he described as its “naive and parochial view” of a national market system and accept the reality of a global market. For example, he says, Microsoft shares could trade worldwide. He sees investors across continents being able to buy U.S. stocks during their own normal business hours in their local currency. But of greater significance to U.S. regulators is that American investors could also trade U.S. stocks in foreign markets, according to Blume. In doing that, they may be able to circumvent some SEC regulations legally and also hide some questionable, and possibly illegal, activities from U.S. surveillance.
In his paper, Blume analyzed current U.S. regulatory efforts, set out the current organization of the equity markets and examined the major issues confronting market players and regulators. Much of the SEC’s current thinking, according to Blume, was shaped by the 1975 Amendments to the Securities Exchange Act of 1934. Among other things, these amendments set as a national goal that all securities should be traded in a national market system. But he says this goal may collide with some of the ongoing structural changes in the equity markets, both domestically and worldwide. He challenged the fallacy that “one market fits all,” stating, “No single market structure will satisfy the needs of all investors. Some fragmentation is a natural result of competition.”
Finding a consensus view on how to define the “best price,” differing needs of investors with respect to execution time of transactions and a preference for non-anonymous markets (that is absent in a national market system using the system of a consolidated limit order book, or CLOB), are some of the forces that spur competition leading to further fragmentation.
In setting out the structural concerns facing tomorrow’s markets, Blume said a major hindrance to the development of a global market is the settlement and clearing mechanism. In the longer term, national borders will no longer confine the trading of domestic securities to their home market. Technologically, the order-gathering function or a market center can be established today anywhere in the world, but the settlement process across borders, which is today cumbersome and costly, is the barrier to locating these functions outside the U.S. As the market centers across nations become more familiar with the settlement process, the cost of settlement will go down, according to Blume.
Further, just as banks in the U.S. locate their credit card activities in states with favorable laws, order-gathering firms and market centers will be able to locate their activities in any country of their choice. Likewise, U.S. investors will be able to enter orders through an order-gathering portal in any country.
In Blume’s view, the ramifications of global trading will be profound since stocks of any country will be traded worldwide at a low cost. It may be that the main market center for any stock will remain in the home country of that stock, but if the market center is not responsive to the needs of investors or if the rules and regulations in the home country become burdensome, the trading of the stocks of that country can and will move to another country.
Blume provided a telling example to explain this scenario. In 1986 Sweden imposed a transfer tax initially on stocks and later on options and futures. With that, trading on the Stockholm Stock Exchange almost ceased as investors moved their trading activities to Wall Street and London. The tax was repealed in 1990, after which trading returned to Sweden. This shift in markets occurred even without a global settlement system. In another example, the U.S. in 1963 imposed an interest equalization tax on foreign bonds purchased in the U.S. Almost immediately, the Euro-Bond market developed for trading such bonds to avoid this tax. However, this market did not return to the U.S. when the tax was subsequently eliminated.
The threat to move to another country will limit the ability of the SEC and other regulators to impose their will. This threat would be mitigated if some investors prefer to keep their trading in this country in the belief that the U.S. regulatory framework provides enhanced protection against fraud, manipulation, and so on.
Blume drew attention to the regulatory issues facing the SEC in a global market by raising questions for which the SEC may not find easy answers: A sampling:
How will the U.S. ensure the integrity of the settlement process across nations?
Insider trading laws and their enforcement differ from one country to another. How will the U.S. enforce its own laws?
If U.S. retail investors begin to trade non-U.S. equities in foreign markets, what steps should U.S. regulators take to protect such investors?
Stockholder rights differ from one country to another. Will a company that discloses information in the U.S. according to U.S. rules be subject to litigation in another country that has different rules?
What regulatory authority, if any, will protect a U.S. investor who buys a U.S. stock through an electronic portal located outside the U.S.?
The U.S. currently regulates margin through the lenders, not the investors who use margins. Will individuals be able to bypass U.S. regulations on margin?
Although the equity markets in the U.S. are fragmented, the consolidated reporting of last trades and quotes provides a great deal of transparency. If a firm like Microsoft can be traded in any country, how can such transparency be maintained?
Blume called upon U.S. regulatory bodies to change their focus from the regulation of a domestic U.S. equity market to the challenges of regulating in a global market.