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Bringing Back Market Transparency

As regulators work to fix some of the problems caused by the financial markets’ changing infrastructure, five questions need to be addressed.

For a year and half after the financial market downturn in 2008, the popular and political impetus for increased financial-services regulation focused primarily on wholesale and investment banks — especially on bankers’ pay and the “too big to fail” problem. At the same time, however, regulators around the world were also studying the rapid rise of alternative trading venues (ATVs) such as multilateral trading facilities (MTFs) or “dark pools” (which serve as repositories of liquidity where trades can be executed in an anonymous fashion) and internal crossing networks. These new types of market infrastructure arose in response to regulatory changes between 2006 and 2008 that aimed to increase competition in global capital markets, such as the European Union’s Markets in Financial Instruments Directive (MiFID) and the U.S. Securities and Exchange Commission’s Regulation National Market System (Reg NMS).

Although competition has increased and trading costs have come down significantly over the last few years, regulators have become concerned about the fast pace of change. The rise of ATVs has resulted in a lack of transparency not only in the nature of trading itself, but also in the clearing and settlement of trades. This makes it difficult to get a holistic view of overall risk in the system. In the wake of the dramatic, record-setting volatility that upset the markets over the last 18 months, it seems likely that regulatory attention on trading institutions and infrastructure in general — and ATVs in particular — will increase significantly.

The changes in the trading and financial-markets infrastructure tend to be little understood outside the financial-services industry. They include, for example, the increasing prevalence of algorithmic trading (in which computer programs determine and execute trades automatically) and over-the-counter (OTC) derivatives trading. The ability to execute trades in a much shorter period of time together with significant decreases in trading costs have led to a rapid increase in the volume of what is known as high-frequency trading — a special class of algorithmic trading whereby a software algorithm initiates orders based on information received electronically, much faster than human traders are capable of processing the information they observe.

The advent of ATVs is both a cause and an effect of these changes. ATVs were started by banks and large broker-dealers to execute trades in a more cost-effective manner; they scan their order books electronically to match buy and sell orders for institutional clients and execute the trades themselves via internal crossing engines without having to route them directly to a traditional exchange, thus avoiding the associated exchange fees. A number of ATVs also offer clearing and settlement arrangements that aim to lower the considerable costs associated with these activities in Europe, and to bring them more in line with the lower costs — as much as 10 times lower — found in the United States.

There are currently between 10 and 20 significant MTFs, including Chi-X, BATS, and Turquoise (which was acquired by the London Stock Exchange in late 2009). These new entities now account for significant shares of trading volume; the larger ones, on some days, can each account for more than 10 percent of total trading in an international marketplace and up to 40 percent of individual shares’ volume on a given day. The MTFs are also expanding globally, from their initial footholds in Europe and the U.S. to Asia, Australia, and South America. The growth of ATVs parallels the rise of algorithmic trading and internal crossing networks, which enable institutional traders to exploit market inefficiencies or divide large trades into smaller trades. Accordingly, as the volume of trading has increased, the average size of a trade has fallen dramatically.

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