Financial News’s invitation to look forward struck me as a good opportunity to look back as well. Ten years ago I published a book entitled The European Equity Markets, in which I made a number of predictions about the development of European market structure, moving into the new millennium. I dusted it off to see how I’d done.
The mark against me would be that I was too bullish on the role of the buy-side in driving disintermediation and market structure innovation. Bundled commissions have kept broker-middlemen firmly in the picture, even if sell-side margins have been squeezed. Nonetheless, I remain bullish on the buy-side. The main reason is to be found in the meteoric rise of hedge funds and the coming divorce between demutualized exchanges and their broker members. The hedge funds are less dependent on bundled sell-side services than their traditional pension and mutual fund counterparts, and far more aggressive in their demands for direct access. The exchanges, now with hedge funds as major shareholders, have every incentive to compete aggressively against broker internalization by taking their customers. Furthermore, Liquidnet has in the past several years demonstrated that a buy-side-only block trading platform can attract significant volume in the US, and I have little doubt that its success will be replicated in Europe.
On the plus side of my scorecard, I was an early apostle of the Stockholm-initiated exchange demutualization movement, and can with some justification claim the mantle of its high priest on the late 1990s conference circuit. I was also rightly bearish on exchange collaboration initiatives - all of which have been feeble, money-burning public relations exercises – and right on time with my bullish prediction of post-euro exchange mergers (Euronext launched in 2000).
Re-reading my analysis of the Investment Services Directive (ISD), now celebrating its 10th birthday, my praise for the liberalizing thrust of the “mutual recognition” and “home country control” provisions, as well as my concern over loopholes which would allow for host state protectionism, appear to have been justified. No doubt, the tremendous expansion of cross-border remote trading owes much to the vision of a truly competitive pan-European securities market enshrined in the European Commission’s original 1988 draft directive. On the other hand, Italy’s steadfast protection of MTS’s monopoly in Italian government securities trading, for example, was consistent with its protectionist negotiating stance in rewriting the Commission’s draft – Italy, with Spain, voted against the ISD. The Article 14.3 “concentration provisions”, inserted by the Council of Ministers with the support of southern member states, have been successfully invoked by several states to inhibit trading off the national exchange.
When in the late 1990s I began preaching in the US on the coming European-led revolution in the exchange business, I was greeted with a combination of amusement and bemusement. Exchange demutualization was painted by the SEC as being positively dangerous, as if mutualization were somehow synonymous with public charity. Now, of course, publicly traded Deutsche Börse and Euronext are seen as being templates for modern multi-asset exchanges, even by regulators, and London, with the aid of a resurgent LSE, has established itself as the fastest growing center for global hedge fund trading and capital raising.
Make no mistake about it: regulation has had everything to do with the rise of the European exchange space, and the relative stagnation of the US, over the past 10 years. While Europe embraced the most radical pro-competitive market liberalization regime ever seen – mutual recognition, or “I bring my rulebook into your market” – Nasdaq virtually collapsed under the weight of misguided SEC interventions to prevent it from competing with dealers or ECNs, and the NYSE sputtered under an SEC-sanctioned governance regime rife with egregious conflicts of interest. But is this set to change?
No doubt the SEC is learning that global competition means accommodating market demand, at least after all other options are exhausted. Unfortunately, Reg NMS looms as yet another expensive, market-distorting monstrosity, which will have to be patched up by a future cast of bureaucrats after the regulatory arbitrageurs exploit its logical inconsistencies.
Europe, however, as I long feared it would, has rediscovered its interventionist soul. Not satisfied to build on the obvious successes of leaving market structure to the market, the Commission has ushered forth MiFID to bring it under bureaucratic control. Whereas the most successful market structure innovation in nearly 40 years, Liquidnet, is built on the elimination of pre-trade transparency, Europe will now mandate it. This will lead to vast and unnecessary technology and compliance expense, while discouraging innovation where it is clearly needed most – institutional block trading.
If there is a silver lining here, it is to be found in the Nasdaq bid for the LSE, which, one way or another, will finally give birth to the transatlantic marketplace I pled the case for in a 2002 study, Building a Transatlantic Securities Market. I am hopeful, if not quite confident, that the jurisdiction-shopping a transatlantic exchange will encourage will pressure both the SEC and the European Commission to tread more delicately in the area of market structure regulation. The signs are already positive: the SEC is making the right noises about accommodating International Financial Reporting Rules, releasing foreign issuers from the “roach motel” of a US listing, and deepening cooperation with the Financial Services Authority.
If there is one area where the European Commission should intervene to encourage competition it is in that dull but critical area of post-trade plumbing, otherwise known as clearing and settlement. The glorious price war between the LSE and Euronext for Dutch share trading was only possible because the two used a common clearing platform – LCH. But Deutsche Börse’s banning of outside access to Clearstream following its 2002 takeover showed clearly that vertical silos could and would be used to block competition. It is not necessary for Europe to copy the SEC’s model of establishing a single clearing and settlement utility by fiat, but it is necessary to restore the urge to merge among Europe’s myriad operators by breaking the exchange stranglehold. This is the only way to get cross-border trading costs down towards national levels. Less MiFID and more competition will go a long way in extending Europe’s glorious trading revolution another ten years.
Dr. Benn Steil is Director of International Economics at the Council on Foreign Relations, a non-executive director of virt-x, and co-author of Financial Statecraft: The Role of Financial Markets in American Foreign Policy.