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Bringing Back Market Transparency

Another concern that regulators have raised is that the prevalence of ATVs has increased counterparty risk at the clearing and settlement stage. This is an important part of the trading value chain that often receives less attention than the more visible activity of buying and selling. The danger is that in the event of sudden market moves — or a market breakdown — it might be possible that investors and traders would not have sufficient information about the counterparties with whom they are dealing, which would further increase counterparty risk.

Fears about counterparty risk may have played a role in discouraging trading during the period of high volatility in May, during which some market participants feared that a mechanical or computer error might have distorted trading. Market participants are also still mindful of the losses incurred after the collapse of Lehman Brothers in 2008. This may add impetus to regulators’ calls for consolidation of off-exchange (OTC and ATV-based) and dark-pool trading — and for potentially combining many of the MTFs and moving their clearing and settlement activities onto one or more exchanges. In the U.S., the DTCC performs the central clearing and settlement function, but there is no equivalent in Europe at present.

Consolidation, however, could also be counterproductive. Concentrating trading and clearing and settlement activities onto a few, or even onto one, provider could have the unintended effect of increasing counterparty risk for investors, because the exchange itself then becomes, in effect, the counterparty. It is thus necessary to balance the need to find a cost-effective solution to minimize counterparty risk against the need to maintain a viable trading and clearing/settlement environment. It’s worth remembering that in the Lehman Brothers failure, many of the repercussions arose because a number of financial institutions and traders were dealing directly with Lehman Brothers, which had, in effect, concentrated the counterparty risk on a single entity.

3. What are the implications for wholesale and investment banks? As trading has become more competitive, bankers have benefited from increased access to a widening selection of trading venues, access to a wider range of asset classes, and falling transaction costs. In addition, market liquidity was increasing, and risk seemed to be decreasing, as a result of standardization and reduced human intervention. But at the same time, bankers needed to seek out highly efficient technical solutions to take advantage of the more sophisticated trading infrastructure. The need to make improvements in this area will continue. These technology-driven initiatives may also provide opportunities for banks, because larger firms can adapt better, and may also be able to afford to build efficient trading engines for other, smaller organizations.

Regulatory initiatives that tend to lessen competition, however, would compel bankers to become even better at assessing and managing risk, as counterparty risk could become concentrated in fewer entities. They may also need to accept that the favorable bid/ask spreads that they have become accustomed to may be adversely affected by the imperative to increase overall stability in the system — which would consequently have an impact on the business model of many financial institutions (i.e., through reduced profitability of certain trading desks).

4. What are the implications for exchanges? For the “traditional” exchanges that hold the incumbent position in securities trading, the shift in volume to ATVs has posed a challenge — not just to their market positions, but to their very business models, including their revenue models and cost structures, their functionality, and thus the degree of vertical integration that they employ. The exchanges have been responding by entering the ATV space to compete in other markets (such as clearing and settlement), as well as expanding into new geographies, either by establishing their own subsidiaries or through M&A, such as the LSE’s acquisition of Turquoise.

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