The Role of Exchanges in the New Economic Order

Author Name: 
Ronald Arculli, Chairman, HKEx

The old economic order, the recent financial crisis showed, was not sustainable. Developed countries were living beyond their means, and risk management measures across the financial chain with limited exceptions were inadequate to prevent the situation from worsening and eventually resulting in a systemic collapse that affected all of us. 

The financial crisis was a catalyst for profound change in the global economy and signaled the end of an era. Wealthy nations are no longer viewed as natural investor safe havens or ideal role models. I would like to offer my observation on the new economic order and in particular the role of exchanges  


Reordering of World Economy 

We are seeing the gradual but definite rise of a number of leading developing countries in Asia and Latin America. No better illustration of this shift in power than the fact that the influence of G7 may be reducing. It is now the G20. 

Having said that, media and academic speculation that the E7 – the Emerging Seven – China, India, Brazil, Russia, Turkey, Indonesia and Mexico – could eventually become stronger than the G7 maybe somewhat premature given that the GDP of Europe, the USA and Japan combined is still some US$34 trillion compared to the E7 GDP of US$11 trillion. 

Another indication is information from the World Federation of Exchanges (WFE), which shows the value of trading in 2009 on stock exchanges in the Asia-Pacific region overtook that in Europe and the trend is continuing this year.   The WFE represents 52 regulated exchanges globally and both Shanghai Stock Exchange and HKEx are active members on the WFE board.

The latest data for May shows that about US$1.4 trillion in shares were traded on its 16 Asia-Pacific members, compared with US$1.2 trillion for its 26 members in Europe, the Middle East and Africa combined. Similarly, the Asia-Pacific market cap is ahead at US$14 trillion versus US$12.1 trillion. The six bourses in the Americas still lead in terms of market cap at US$19.3 trillion as well as shares traded at US$3.8 trillion for May. But Asia Pacific is gaining ground. 

Overall, the total market cap of all WFE members at the end of May 2010 stood at US$45.2 trillion. But not all is rosy for stock exchanges. Just as the macro economic landscape is being transformed, the exchange landscape has also undergone tremendous change. 

Whatever the speculation or numbers, one trend is clear: the world is repositioning itself towards multipolar sources of growth with economic power more broadly distributed than before.

 I say this because the progressively more affluent countries, not burdened by excessive debt, are seeking worldwide investments that offer them good returns. Worldwide investors, in turn, are staking more capital in emerging countries for the potential they offer. Global investment flows are expanding. 

Evolving Exchange Landscape 

This change has its origins in the shift of exchanges from being member organisations to demutualised, for-profit, and often listed entities. These exchanges have to take into account the interests of the overall market and a broad range of stakeholders, not just one segment. 

In a sense, a divorce has occurred. One consequence is that intermediaries have decided to set up their own automated trading systems to trade among themselves and for their clients, and bypass the traditional exchanges. 

Rapid advances in technology have made this possible and, as crucially, deregulation in the name of competition in the US and Europe has enabled alternative trading venues to compete with exchanges. 

The mushrooming of these alternative venues is creating an increasingly fragmented market structure. In the US alone, there are about 37 alternative trading systems and more than 200 broker-dealers that execute orders internally. The New York Stock Exchange’s market share of total trade is about 35 per cent. This compares with about 80 per cent in 2004. Nasdaq, the London Stock Exchange and other incumbents in Europe have also seen market share erosion to new players. And this erosion could continue. 

Many of the new trading platforms can execute thousands of orders to buy and sell stocks within seconds on both on-exchange and off-exchange platforms to profit or arbitrage on small price differences. It is estimated that this high frequency trading accounts for 60 - 70 per cent or more of the trading volume in US equities. 

This fragmentation in liquidity also means that some of these trading venues, such as dark pools, are not accessible to the public who do not have the same resources as institutions and will therefore not have access to the best prices at the same time.   Indeed, some opinion leaders have questioned the social purpose of many recent financial innovations.

Regulatory Challenges  

These developments pose challenges to regulators and regulated exchanges. There is unequal access to markets and the fair price discovery process is impeded because a portion of demand and supply for a stock is effectively concealed. 

Indeed, many question how real the added new liquidity is. Software programmes can rapidly generate a vast number of orders, which in turn can then trigger even more orders. But this loop also works in reverse whereby liquidity can very rapidly disappear. 

We saw how the market plunged on 6 May in the US in the “Flash Crash”. Newer trading methods could result in higher highs and lower lows: greater volatility and with more frequency. A more unstable market could ensue, and it cannot be characterised with greater true liquidity – if by that we mean the ability to buy or sell an asset in the market with ease and with minimal impact on the share price. 

In the aftermath of the May 6 crash, the US SEC has put in place a pilot circuit breaker programme whereby trading of an S&P500 stock that moves 10 per cent or more in a five-minute period is halted for five minutes. Trading halts are disruptive events and can affect public perception and their ability to trade. Are the “safeguards” for the new high-speed marketplace impeding more traditional investments and opportunities for ordinary market participants?  

Arguably, when shares are held only for fractions of a second, it is no longer about participating in the ownership of a company or ensuring it is well run. The opaqueness of trading, and its fragmentation have negative implications for effective corporate governance.

Furthermore alternative trading platforms do not regulate securities issuers. In a sense, investors in these venues have to adopt a ‘caveat emptor’ or buyer-beware approach. Meanwhile, on the flip side, the standards that traditional exchanges maintain, and are indeed required to have, remain high. We must then ask: why are some share trading venues not subject to the same rules and requirements as others? And what is the regulatory objective – to protect investors, ensure fairness, or to simply promote competition? Although one role exchanges have may be under challenge by these alternative platforms, other significant functions have not. Some examples are: fair and efficient price discovery, strong fund-raising capability, an effective issuer regulatory framework and central party clearing – to name a few.

The playing field is far from level for all investors, nor indeed for all trading venues. This is likely to have long-term negative ramifications for both.

Unparalleled Value Proposition 

I now turn to the unparalleled value proposition of Exchanges. Let me start with the first. The regulated exchange environment provides for transparent price discovery, with visibility of the bid and offer prices shown in the central order book. This is not always true for the newer trading venues. Another advantage traditional exchanges have is the capability to help companies raise capital in a cost-effective manner. The new trading platforms have yet be able to gain traction in this area and are in a large part secondary trading venues for institutional investors only. 

The capability to raise IPO funds and post-IPO funds is key to economic development. It enables companies to grow and industries to flourish. 

The listing of a firm on a regulated exchange in itself serves as an important signal for investors. It indicates the issuer has been able to meet the exchange’s initial requirements and is willing to commit itself to ongoing obligations, be it disclosure or complying with international best practices and standards. 

It can improve a company’s operations, management and corporate governance standards by opening the firm to public and media scrutiny and by the rules and regulations it has to adhere to. 

For the system as a whole, central clearing of trades facilitates regulatory oversight by providing a single location for access to information on the extent of market participants’ potential liabilities. The recent financial crisis showed the large over-the-counter (OTC) positions taken by various firms could not be monitored because of the lack of transparency and disclosure. 

OTC derivatives need to be traded in an open market to avoid a similar situation to the one we witnessed recently which saw a number of large financial institutions on the brink of bankruptcy. 

Currently, there are proposals in the US and Europe to ensure more OTC derivatives to be traded on exchanges, and cleared centrally to safeguard the financial system against a fallout similar to the default of Lehman Brothers. However, there is much lobbying against the move, fearing a drain on corporate cash to meet collateral requirements. We are already seeing a divergence in the US and European reform approach, with US offering companies more exemptions. The risk of regulatory arbitrage could limit the efficacy of such measures and the role exchanges can play in strengthening the financial system. 

In sum, alternative trading platforms do not offer the same price visibility or quality control assurance regulated exchanges do, nor the risk management features. There is no governance relationship between the issuer and the new trading venues. These platforms are fragmenting liquidity in the name of low cost and high speed. 

It has to be remembered that the provision of liquidity is a primary driver in a company’s willingness to list on a particular exchange and be subject to its rules. Should this liquidity continue to be increasingly fragmented will companies still be willing to subject themselves to stringent exchange requirements? How will this affect fund-raising activity, investor behaviour, or economic progress in the long run? And what are the implications on the development of corporate governance and the stability of financial markets? 

Exchanges’ Response 

To combat market share erosion and a fall in trading revenues, which has traditionally formed the largest component of exchanges’ income, the regulated stock exchanges in the US and Europe have responded in a variety of ways, including cutting fees as well as post-trade costs, and adding new businesses to diversify their sources of revenue. How successful these changes are remain to be seen. 

The situation in Asia is somewhat different as many Asian markets, such as the one in Hong Kong, have restrictions on the setting up of alternative share trading venues. While such off-exchange trading is still in the early stages in Asia, making up a small percentage of the average daily turnover, in a globalised marketplace we cannot afford to ignore the issues they raise. 

Whilst I have outlined some of the shortcomings these new developments pose, it is clear that exchanges cannot be complacent and need to study ways to continue to add value and adjust and refine their services. Investors, especially institutional ones, are seeking better services for evolving methods of trading which exchanges or regulators in Asia and elsewhere must take into account. 

While protecting investors and maintaining market integrity, we have to find ways to improve our platforms and functionality to offer best execution to accommodate new trading strategies in a fair manner, as well as offer efficient pre- and post-trade services in order to stay competitive. 

As exchanges, we are not adverse to competition. Competition is not a new phenomenon, nor is it to be feared. Global exchanges have been competing for years. Just recently we learned how NYSE Euronext is stepping up competition with the London Stock Exchange by launching a listing platform in the UK. But exchanges have also been cooperating over the years as well. Indeed the WFE, set up to discuss industry issues and share experiences, also offers its members guidance on improvements to their business standards and practices. 

The WFE is not seeking to stop the growth of new trading platforms, but rather to ensure that there is a level playing field for the responsibilities assumed by all securities market order execution venues, and for more uniform rules between exchange-traded and less-regulated markets. Only then can we ensure a fair and stable trading environment and continued advancement of both developing and developed economies. 

The robustness of the regulated exchange model was re-affirmed during the financial crisis when exchanges continued to offer their services without disruption. They were able to provide much-needed liquidity even on days when the OTC and interbank market segments seized up. 


What the immediate horizon holds, I cannot predict but I am confident of the long-term potential the rising China market and other emerging markets have to offer to investors and market participants in a new financial order. 

Capital markets and exchanges in Asia as well as those with ties to them have good prospects for growth. What we need is for all trading venues to be properly regulated and for them to fulfill their roles. Worldwide regulators and all exchange trading venues must also work in tandem to minimise the risk of regulatory arbitrage. 

Developments that strengthen our markets and make them more effective and efficient are to be welcomed. But those that can intensify systemic risk or disadvantage a certain segment of investors to the benefit of others raise concerns. 

In the face of rapid innovation and constant change, perhaps it is time to return to basics and remind ourselves of the true functions of financial markets. Computer-generated liquidity is already affecting real liquidity and altering trading activity. We run the risk of having it all just be a mathematical playground for the few to the detriment of many. A piecemeal approach seems inadequate to these vast changes. Perhaps a more fundamental reassessment of how to achieve the right balance between humans and technology in the financial field is called for. We need to focus on what really adds economic value and how to ensure market integrity and fairness. 

Amid the evolving environment, we as regulated stock exchanges know we have to seek to strengthen our operations, products and services. But it is vital we have the support of market participants and regulators for us to effectively fulfill our responsibilities and efficiently complement economic development. While it is impossible to ensure against all risk, it is incumbent on us all to be cognizant of both the opportunities and challenges we are faced with, and act accordingly for sustainable global progress. 

Perhaps it is worth noting that the WFE members helped companies raise US$1,010 billion in IPO and post-IPO funds in 2008, and US$1,054 billion in 2009. From 1 January to 30 June 2010, about US$281 billion has been raised. Surely there is a crucial role for the 52 WFE members in the New Economic Order. Would you not agree?

About Ronald Arculli

Ronald Arculli is currently a Non-Official Member of the Executive Council of the Hong Kong Special Administrative Region Government and Chairman of Hong Kong Exchanges and Clearing Limited. Effective January 2010, Mr. Arculli serves as the Vice Chairman and Board Director of the World Federation of Exchanges. He is the senior partner of King & Wood, the Hong Kong Office of the largest law firm in Mainland China. He also serves on the boards of several major listed companies in Hong Kong. In 2000, he succeeded HRH the Duke of Edinburgh as Chairman of The International Award Association, a youth development program present in some 100 countries – a position he held until November 2007. In October 2008, he is appointed by the HKSAR Government as a Member of the Board of the West Kowloon Cultural District Authority, which is responsible for a HKD 21.6 billion art and cultural project. Mr. Arculli has a long and distinguished record of public service as a former member of the Legislative Council of Hong Kong and has served on many commissions and boards, including the Board of the Hong Kong Jockey Club and the Board of Governors of the London Business School. He also served as the Chairman of the Hong Kong Jockey Club between 2002 and August 2006. In November 2005, the City University of Hong Kong conferred on Mr. Arculli an Honorary Degree of Doctor of Social Sciences.