The three main advantages of off-exchange trading that ATVs offer institutional investors are lower transaction costs, speed, and anonymity. Trades are executed almost instantly (literally — they are often accomplished in one thousandth of the time it takes for an eye to blink), allowing investors to buy or sell large blocks of securities without moving the stock prices to their disadvantage. In addition, investors and traders can trade anonymously to avoid speculation about large trades that financial institutions are executing on behalf of clients or themselves. ATVs also provide far lower transaction costs than traditional exchange-based trading, because they can be operated with small staffs and less infrastructure.
A prevailing sentiment among many market participants, in particular institutional investors on the buy side and regulators, is that the proliferation of ATVs is to a large extent counterproductive. There are two main reasons. First, the decline in market transparency is creating a need to centralize the price aggregation function formerly performed by traditional securities exchanges. Second, the proliferation of ATVs has tended to increase counterparty risk at the settlement and clearing stage in the event of market disruptions. Several new regulatory proposals have been introduced to address these concerns.
These regulatory changes are likely to result in a reshaping of the markets that will affect banks, traders, and investors — as well as the ATVs and the securities exchanges themselves. But there is also a danger that the specific changes could have negative unintended consequences, ultimately impairing the overall effectiveness of markets and increasing costs for investors unnecessarily. To avoid this, we believe that regulators should approach the problem holistically. As they do so, five essential questions need to be considered by all the parties involved.
1. Why has transparency been impaired? Before the rise of ATVs, traditional securities exchanges performed the roles of transaction aggregators and dispersers of price information. There were fewer than half a dozen exchanges that mattered, so bankers and traders could easily monitor them. The introduction of ATVs gave rise to increased concerns of regulators and other market observers about whether these facilities’ off-exchange trades were being revealed and reported, in a timely manner, on the consolidated tape, and whether trades were in fact being ultimately made public. The market sentiment is that the proliferation of ATVs has clearly reduced overall transparency. At the very least, there is a need for new structures or new players to aggregate prices and increase transparency.
This became especially clear during the markets’ episode of unusually high volatility in early May 2010. Prices of some financial instruments gyrated wildly, with stock prices of blue chip companies moving up and down by dozens of percentage points in the space of a few minutes. Investors were baffled; some of the ATVs were themselves so unsure about the real level of prices that they ceased trading altogether. Weeks after the events, there was still no common understanding about what had in fact gone wrong. Well-designed initiatives to improve the transparency of ATV trading and the subsequent clearing and settlement thus seem like a sound idea — through, for example, a real-time price consolidation/discovery mechanism and the establishment of a European Central Counterparty Clearing along the lines of the Depository Trust & Clearing Corporation (DTCC) in the U.S.
2. Would limiting the proliferation of ATVs, and moving more trading to traditional exchanges, decrease the overall risk in the markets? The answer to this question is less clear-cut. The original idea in encouraging new trading entities was that they would increase competition and overall market liquidity. Those two objectives seem to have been reached — at least when the markets are operating normally. But the market disruption in May revealed that liquidity problems could arise quickly during periods of high volatility and be compounded by the lack of transparency.