2023-06-02 10:23:41 ET
Summary
- London and other European exchanges should focus on the investor side of transactions to gain a competitive advantage over U.S. markets.
- London can avoid the mistakes made by the U.S. Securities and Exchange Commission, which has driven natural business orders to wholesalers and alternative trading systems.
- Initiatives for London exchanges could include investor-friendly listings, reducing clearing costs, and eliminating inter-exchange arbitrage.
Introduction
There is concern in London and elsewhere in Europe that U.S. markets are expanding their lead over European exchanges. The London Stock Exchange (LDNXF) (LNSTY) (LSEG.L) has been the focal point in bewailing London’s decline. The proximate source of concern is the departure of tech firm ARM from the LSE to a New York venue. (Read here , and here .) A variety of causes have been identified, perhaps most prominently the shift of the UK’s defined benefit funds from equity investments to debt investments.
But pointing a finger at investor decisions, even those induced by regulators is a loser’s game. The solution, if there is to be one, must rest with the markets themselves. The fatal flaw of global marketplaces is blindness to investor needs. This failure leads to mistakes such as failure of exchange and other market middlemen to adjust their offerings to meet investor needs. This failure is not unique to Europe. American exchanges also show little interest in modifying the offerings of listing firms to maximize investor value.
A new focus on the investor side of transactions is an opportunity that London and other European exchanges should seize.
The status quo in America.
From London’s point of view, the American exchanges seem all-powerful. But from a domestic American standpoint, the American exchanges’ recent history is one of growing vulnerability. Both major financial markets – securities and futures – are in trouble. And importantly for London, the problems for both markets are created by failures in market structure. If London sees the American failures and avoids them with a superior market structure, there is no ceiling on the growth of the London markets in our still-global market system.
American securities exchanges.
American securities exchanges are suffering a gradual decline into chaos, driven by two issues. Poor adaptation to electronic trading, and for-profit publicly held exchange management firms.
The SEC’s National Market System ((NMS)). The source of most American securities market problems is the inadvertent negative effect of the NMS. Unexpected effects include a proliferation of exchanges trading the same securities and a departure of “natural business” (retail and institutional long-term investors) from direct exchange trading altogether. Long-term investors need Wall Street gatekeepers to enter the NMS on their behalf. In effect, American investment brokers have brokers too, adding another layer of complexity and cost to the process of investing.
Exchange proliferation, combined with the computer-driven arbitrage that drove natural business to the sidelines, has turned the American financial market structure into a transaction cost monster and created a bizarre need for retail and institutional brokers to pay gatekeeper firms called wholesalers (retail investors) or Alternative Trading Systems (ATS, institutional traders) to find a way to fill an order without drawing SEC fines.
Securities exchange trading has become a multiple-node electronic computer-based network exercise in high-speed trading. Algorithm-driven computer-initiated orders only. No retail or institutional transactions without paying the gatekeepers, please.
Retail brokers and retail investors have been completely driven out of the exchanges because retail brokers find it impossible to tell in advance which exchange has the best price at any given point in time. As a result, retail brokers have been forced to sell their orders to wholesale brokers in exchange for payments called Payment for Order Flow (PFOF).
The disastrous American situation in securities trading appears to be permanent. The SEC seems unable to implement simple obvious solutions such as requiring exchange management firms to colocate their exchange transaction engines. Instead, current SEC proposals if adopted will complicate a system that is already too complex, adding another layer of exchanges for pricing PFOF.
The enormous unnecessary overhead associated with funding 13+ exchanges in a marketplace that should be supporting three at maximum should create a competitive opportunity for the UK/London exchange community. But to gain more than a temporary competitive advantage, the London community must do more than simply avoid the mistakes of the NMS.
American futures exchanges.
The American futures exchanges have problems as well.
A wager, not an investment. The biggest problem of futures markets in competition with any securities exchange is that futures are not investments. They are essentially a wager on the future price of a security or commodity.
Passive ETFs have exploited this weakness, sapping trading of stock index futures by imitating some of the important resource cost advantages of stock index futures and providing investments as well. This futures shortcoming suggests an opening for a new London exchange that blends the parsimonious resource costs of futures with a market for investments.
Lack of control of the spot market that generates the futures settlement price. Eurodollar futures, until recently the largest futures market measured by open interest, have lost their settlement price, the London Interbank Offer Rate (LIBOR). When the financial market regulators did away with LIBOR, they exposed the second critical weakness of futures markets. Futures markets have no control over the spot markets that determine the value of futures contracts. If short-term interest rate futures had created a linked spot settlement market, they could have taken responsibility for the health of the spot market and thus reduce vulnerability to spot market failure like that which destroyed Eurodollar futures.
Both issues are a problem for every futures market.
The UK opportunity.
The precedent for a London market coup. The London markets may have established their position second to New York by welcoming derivatives in the early 80s. Short-term interest rate futures and interest rate swaps were unpopular among the New York/Washington power brokers at the time. The London community’s positive attitude toward opening its markets to derivatives trading was rewarded when both major short-term debt instruments based their prices on the London-market-created London Interbank Offered Rate (LIBOR). UK regulators also accepted financial futures trading at a time when American regulators were less supportive. (Here is a brief history of LIBOR.) But like all human creations, LIBOR had flaws that ultimately led to its end.
Can London repeat it? Where then, can London take its markets to reestablish its reputation as a market innovator? The answer lies in two fundamental positive qualities of London markets.
- Regulators are willing to consider the profitability of market participants among their concerns.
- Market participants that consider joint profitability collectively pay less attention to their bottom lines.
These qualities give London a potential advantage over American markets. The question is, how can London protect or improve its number two position?
London’s current competitive position.
The threat. In March of this year, the chipmaker ARM announced its intention to move its primary stock listing to an American exchange (read here ). This seems to have generated concern for the future of London markets.
ARM has many reasons to move its listing.
- Regulatory red tape such as the FCA rules governing related party transactions .
- Over the last three decades, the UK has enacted regulatory measures that have forced fund managers to redirect money from stocks to bonds (read here ).
- Listers believe that London investors have lost their risk appetite .
- UK investors have been replaced by foreign investors.
Proposed solutions.
What not to do. The disappointing failure of London to gain ground on New York may have been due to London’s imitation of American markets instead of finding unique answers.
London shares with other marketplaces a single objective. Listings. But London should not share the American approach – selling the same product with a different name.
One exchange leader, Jos Schmitt, Co-Founder, President & CEO of CBOE Canada agrees . “We came to the conclusion that from a capital formation perspective, there are gaps where a new, innovative listings exchange, thinking and operating in a different way, could truly add value.”
Another leader, Stéphane Boujnah, chief executive of Euronext, told the Financial Times that EU plans for a consolidated live database of stock and bond prices trading across Europe (imitating the Securities Information Processor (SIP)) could create a wealth of trading opportunities for bigger firms with greater reach while harming smaller investors by leaving them unable to access the best prices.
This is exactly what the SIP has done in America. And with the effect Buojnah describes. But where in America the disastrous proliferation of exchanges has forced the SEC to find some pre-transaction standard for an acceptable quality of prices by creating SIP, Europe has not yet put itself into this absurd position,
Intentionally or not, America has created a market that drives natural business orders to go knocking on the door of the big wholesalers and ATS to gain market access. London can still make a major dent in market share by avoiding SEC mistakes, leaving the exchange doors open for natural business.
What could be done in London?
There are at least three major initiatives that an exchange seeking to gain a larger share of financial exchange-traded transactions could pursue. But these changes exploit one of London’s major advantages, innovation-friendly regulators. Here is a menu of aggressive changes.
- List securities that move the exchange focus on the issuer side of the trade to the investor side of the trade.
- Reduce clearing costs.
- Eliminate inter-exchange arbitrage.
Investor-friendly listings. This most important change is fundamental and simple to initiate, but for enduring capture of a maximum of investor business, there are more innovative changes that might well require regulatory involvement.
- Investor ownership. If a London-based marketplace places its ownership in the hands of investors as does Vanguard, for example, newly listed products will automatically tend to better meet investor risk-return issues than do existing securities.
- Self-created listings. To capture listings, the exchange should have an investment creation and self-listing capacity. Using ETFs as a model of the creation of securities listed by the exchange and traded only there. Create an exchange fund manager that plays the same ownership role and security design role as an ETF fund manager. Then listed instruments could be designed to better fit the needs of investors.
- Reduced clearing costs. To reduce clearing costs, separate ownership from the rights to payments as do ETFs.
- Eliminate inter-exchange arbitrage. Establish the exchange as a single point of execution as do futures markets. There can be no inter-exchange arbitrage if only one exchange lists each instrument.
Conclusion.
In the view of some experts, the London markets are in eclipse lately. There are concerns that shortcomings of investors and regulators – especially concern that there is an undue focus on fixed-income investments over equity by UK pension funds – are going to take London’s competitive position further down the leaderboard.
Remedies focus on changing market regulations (see here ). But exchanges should take a closer look at themselves. A more investor-friendly approach and a willingness to innovate will produce results that pointing fingers at regulators and investors will not.
What does this mean for the future of LSEG.L? Certainly nothing in the near term, but in the long term it will determine where the LSE – and other financial markets in London – sink or swim.
For further details see:
Realizing The Potential Of U.K. Exchange Trading