The Greek elections, the Spanish economy, and the viability of the euro have, understandably, become the financial stories of the summer. But here in the US, another debate about the future of domestic markets is quietly underway: Can investors count on US financial markets to remain the most open and transparent in the world?
It’s not an academic question. Investors have withdrawn billions of dollars from US equity markets in recent years, at least in part due to a lack of confidence in market integrity. Last month, the House Financial Services Committee held a hearing on whether the transparency that traditionally characterised US equity markets is rapidly being replaced by opaque trading platforms operating outside public scrutiny.
The evaporating transparency of our equity markets is an unwelcome turn from recent lessons learned. In the wake of the 2008 financial crisis, there was broad consensus that institutional and retail investors need markets to be open and transparent. Indeed, one of the primary regulatory objectives following the financial crisis was to increase the transparency of market trading. Yet, since January 2008, the share of stock trades executed through largely unregulated “dark pools” and other alternative trading venues has nearly tripled.
Undisplayed trading occurs on electronic trading platforms, such as dark pools, operated independently or as part of a larger financial institution. Such venues can serve an important function for investors seeking to trade large blocks of securities. However, undisplayed trading now accounts for a substantial portion of overall equity volume.
Today, approximately 50 dark pools in the US operate largely outside regulatory oversight and, along with equally opaque internal trading operations by major brokers, handle nearly 40 per cent of daily trading volume. For more than 1,200 widely held equities, more than 50 per cent of trades now occur “in the dark” – nearly a 150 per cent increase over the past two years.
The current market structure evolved after the implementation of regulatory changes designed to encourage competition between once-fledgling electronic markets and traditional public equity exchanges. We have embraced this competition, which has led to lower trading costs, tighter spreads, huge investments in technology and other benefits associated with more efficient capital markets.
Unfortunately, these changes have also brought unintended consequences and today we are rapidly approaching a two-tiered market structure in the US.
On one tier, open public exchanges provide full price transparency to all traders and investors. Our exchanges must file extensive data on trading activity with federal regulators who oversee our markets and bear regulatory costs that are exponentially greater than our less regulated competitors.
On the other tier are the dark pools and other non-exchange venues that match anonymous buyers and sellers without displaying prices publicly. These dark markets can even discriminate between certain traders, giving one customer a first look at order flow before showing it to other market participants.
As a result, more high-frequency and institutional traders are moving to these venues where they can trade with less regulatory scrutiny. Retail investors are put at a disadvantage as more and more information is outside the public view and excluded from the price discovery process. As liquidity providers become less willing to publicly display quotes, the price discovery process deteriorates.
Fairly implemented regulation need not be burdensome. Properly designed and equitably applied to all participants, it is a critical component of an open, transparent marketplace.
There is already evidence that the evolution of our two-tiered system is undermining confidence in markets for equity issuers and investors. This erosion of faith in the efficiency and effectiveness of capital markets will ultimately hurt capital formation, thereby damping job creation.
To solve the problem, policy makers should focus on establishing fairer and more transparent equity markets, as well as a more level playing field among the different types of participants, which should result in better equity prices for investors and greater participation in such markets by investors.
There is no need to sacrifice transparency in order to promote competition in financial markets. Both public policy goals can exist in harmony – indeed, they must if we are to restore public faith in our capital markets.
It is time to take a stand for the quality of financial markets and encourage public price discovery. Fairly implemented regulation need not be burdensome. Properly designed and equitably applied to all participants, it is a critical component of an open, transparent marketplace.
Published with the permission of the Financial Times.
About Duncan L. Niederauer
Duncan L. Niederauer is Chief Executive Officer of NYSE Euronext. He is a member of the company's Management Committee and also serves on the Board of Directors.Prior to his current position, Mr. Niederauer was head of U.S. cash equities. Before joining NYSE Euronext in April 2007, he was Managing Director and co-Head of the Equities Division Execution Services for Goldman Sachs & Co. He joined Goldman in 1985 and moved to the Equities Division in 1987. In 2000, Mr. Niederauer relocated to the headquarters of Spear, Leeds & Kellogg, where he managed the fir's global clearing and execution business. He also ran the Equities E-Commerce effort, and was the global head of portfolio trading and spent time in Tokyo in Derivatives and Japanese products. He earned an MBA from Emory University and a BA from Colgate University where he currently serves on the Board of Trustees.