Inside the insiders' realm

What is an Exchange?
May 19, 2000

Most of us will have experienced a visit to a weekly or daily public market, with its stalls of vegetables and meats, to a supermarket or megastore or to an American-style shopping mall. Economists, sociologists and urban planners have long dabbled in research and debate about the public and cultural issues involved in these different methods of distribution of goods.

By contrast, research and debate on financial markets has until recently been the preserve of insiders. Ruben Lee, former fellow of Nuffield College, Oxford, and former vice-president of Salomon Brothers, has opened up the subject in a masterly way to the average intelligent reader. I commend to you unreservedly this very well-written and even better documented volume. A five-page glossary of abbreviations and acronyms and a 33-page bibliography indicate the complexity of the subject, but the writing is clear, and the concepts well presented with case studies.

In his introduction, Lee uses "market" thus - "A market's structure or architecture is the full set of rules governing these three components [data dissemination, order routing and order execution]" - but in the rest of the book he mostly shies away from this terminology, preferring "trading systems" and "exchanges" as providers of trading systems. His preference is perhaps explained by this statement: "It is in the legal and regulatory domain that the definition of the term 'exchange' becomes critical, given the central role that exchanges have historically played in the regulation of trading markets."

Lee states that four broad themes run through the book: that an exchange is a complex issue; "the need to balance an understanding of abstract topics with an appreciation of the minutiae of many variegated contexts"; the importance of technology; and "the struggle between what is believed to lie in the public domain and what is thought to be a matter solely of private concern".

Other aspects of the trading cycle, such as clearing, settlement, custody and delivery, form a small part of the book. This is understandable, given the already dense research requirement arising from the main themes, and justifiable, insofar as these functions are not as crucial to the existence of an exchange as the three identified principal ones.

From recent events, however, and from the ambitions of the management of organisations involved in clearing, delivery, settlement and custody, one can envisage that the the moves and alliances and IT investments made by such organisations may well affect the shape of exchanges in the future.

Chapters two and three are dedicated to governance. One may well think that thinking has moved irreversibly in the direction of for-profit organisations and away from non-profit or consumer cooperative organisations. The author does well to research the pros and cons of all structures, as the internet and public-opinion pressure may spring surprises here in the not-too-distant future.

The following two chapters cover competition and cooperation among exchanges. This is history in the making. Just consider the link-ups between the two opposing sets of European exchanges currently being consummated. Globalisation and global mergers are not leaving the exchanges untouched. Such seeds are planted on fertile ground: exchanges have a long history of cooperation, or at least of attempts at cooperation.

The rest of the book digs deeper academically into the issues of information, law and regulation, with a great wealth of analysis of practical cases, events and policy proposals. Always looming in the background and regularly coming to surface is the issue of transparency and its effect on pricing and on the general effectiveness of the exchanges.

For instance: "A permanent effect of large trades on prices was found (by Board and Sutcliffe in 1995 studying the London Stock Exchange) in the alpha stocks to be 0.23 per cent for customer buys, and -0.18 per cent for customer sells. Although much of the price response occurred in the first trade, the full impact was found to occur only after about 12 subsequent trades, after an average period of about 45 minutes. This suggested to Board and Sutcliffe that market efficiency might be improved if large trades were published immediately."

Indeed, if one cuts to the basics, the real dialectics concerning the exchanges are the perceived opposite interests of large, dominant market makers vis-a-vis smaller intermediaries, investors and issuers of securities, with regard to the likely impact of transparency on trade positioning and on pricing.

I stress the word "perceived" because I strongly doubt that practitioners have spent much time in understanding the real rather than the expected impact of policies and regulations on their balance sheets. Indeed, there is a good possibility that practitioners may fight some rules in the belief that these rules hamper them, whereas, at the macro level, they may ultimately be beneficiaries.

These dialectics and perceived conflicts of interest may prove a big hurdle for some internet-based initiatives for new exchanges, which could benefit both issuers and investors. Large market makers may feel unwilling to back or even "let live" initiatives over which they feel they have no control, although such initiatives might increase the size of the pie for everyone concerned.

Lee, while evaluating the merit and the disadvantages entailed by each major policy or policy proposal, seems to be staying deliberately clear of passing judgement or of trying to forecast the future shape of exchanges, despite the fact that he is probably better qualified than most to do so.

Perhaps a worthwhile follow-up to this book would be for the author or publisher to gather academics, regulators, lawmakers and practitioners and engage them in a serious debate about which rules strengthen exchanges and which just pander to a misinformed public. If that were to occur, those involved in clearing, settlement, custody and delivery should not be forgotten. In fact, if the "new economy" is kept waiting unduly long at the door of the exchanges that already trade new economy shares, I have no doubt that it will find its way in through the back door via ancillary services.

Rudi Bogni is former CEO for private banking, UBS Ag, the largest Swiss bank.

What is an Exchange?: The Automation, Management and Regulation of Financial Markets

Author - Ruben Lee
ISBN - 0 19 828840 9 and 829704 1
Publisher - Oxford University Press
Price - £35.00 and £14.99
Pages - 405

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