CONFIDENCE IN STOCK MARKETS SHAKEN BY VIOLENT SWINGS / THE FINANCIAL TIMES

Confidence in stock markets shaken by violent swings

Philip Stafford

©David Bromley

Violent swings on the world’s stock markets in mid-August led to inevitable searches for the culprits. For some it was risk parity funds, which aim for a diversified portfolio of stocks, bonds and currencies balanced by the mathematical risk of each asset class. They have been likened to the development of portfolio insurance, which played a crucial role in the 1987 stock market crash.

But the heavy activity, especially in the options market, also carried echoes of sharp moves in the past year in fixed income and foreign exchange markets, which were shocked respectively by spikes in US Treasury yields and the Swiss central bank’s removal of its currency peg.

In the storm, order book depth and accurate pricing drained from markets. This revealed the complex relationship between humans and computers and the high-speed, interrelated method with which equities, derivatives, foreign exchange and fixed income are traded.

“First of all you have to start with the market structure,” says Greg Medcraft, chairman of the International Organisation of Securities Commissions, a global body that represents market regulators from 120 jurisdictions. “For example, there’s been a lack of market discipline in the past by banks in taking bonds on to their books. That doesn’t build sustainable liquidity. The way to do it is to be an agent, matching buyers and sellers. They are not investor focused — it’s more on what the issuer wants.”

These bouts of volatility have come along with several high-profile cases of potential manipulation of markets. They have included those involving, most notably, fines for fixing the Libor lending rate and foreign exchange markets, or the charges levelled against Navinder Singh Sarao, the UK trader accused of playing a key role in the US market “flash crash” of 2010. Together they raised the issue of what constitutes fair and effective markets.

 

“If a market is going to work effectively, it’s important that participants have trust and confidence in it,” says Mr Medcraft.

For some, the answer lies in taking market activity into a centralised, electronic venue that displays quotes, in much the same way a stock exchange does. It may not root out bad behaviour but at least provides a trail for authorities to follow.

In the year’s biggest deals, Bats Global Markets, the second-largest US stock exchange, made its first foray away from equities with the $365m purchase of Hotspot, a foreign exchange network, and Deutsche Börse, the German exchanges operator, paid €725m for Germany’s 360T, also a foreign exchange venue.

More electronic trading also produces demands for more data, and exchanges are also looking at new revenue sources.

But despite all this there is a lingering feeling of unfinished business from the financial crisis.

 

More than seven years after Lehman Brothers collapsed the industry is waiting for regulators to finalise rules. Europe is set to unveil its largest piece of legislation for markets, known as Mifid II, in coming weeks, and with it usher in more electronic quote-driven trading in fixed income markets. The continent is likely to begin mandatory clearing for swaps in the next eight months although it has yet to harmonise its post-crisis derivatives clearing rules, most notably with the US.

 

The two markets, which account for 90 per cent of the $700tn market for swaps and futures, have both put in place tough laws for their own jurisdictions but have been unable to reach agreement on common standards and oversight.

Failure to reach agreement would be “catastrophic”, says Eric Litvak, chairman of the International Swaps and Derivatives Association, with many European banks likely to pull out of US clearing houses instead of being hit with punitive additional capital charges that could amount to billions.

“Cross-border issues will preoccupy the industry for the foreseeable future”, says Nandini Sukumar, chief executive of the World Federation of Exchanges. “While Europe is making progress, there is still some way to go. As long as European participants are uncertain about the regulatory status of some third-country clearing houses it will hit everyone’s ability to do business,” she says.

Of equal concern is the effect once the rules are in place. Many are worried about the Basel banking committee’s derivatives leverage ratio for banks, which forces them to hold more capital in the event a counterparty defaults.

The industry has called its application “flawed” and points out that customers’ margin — which would count in the calculations — is already by law segregated from broking activity. Without change, banks and clearing houses warn the requirement could damage the health of the global clearing ecosystem.

“There’s a difference between the bank acting as principal and the bank acting as agent,” says Sunil Cutinho, head of CME Clearing. “Repo [transactions] are allowed, as secure financial transactions. We’re asking for a simple extension to that. Clearing members are a very important part of the system. They facilitate access for the market.”

Whether the banking regulators are willing to move is another matter. “The Financial Stability Board have reluctantly reopened the case but as to whether they act, it’s 50-50,” says one senior derivatives trading executive.

Beyond that, exchanges and clearing houses are mindful of interaction with a fast-changing digital world. Cyber crime is a worry but one answer might be blockchain technology, the complex marriage of computing power and finance that underpins bitcoin, the controversial cryptocurrency.

Financial products have fused with technology, notably in the electromagnetic strip on a credit card.

 

However it cannot guarantee the user is verified. The blockchain aims to take that one stage further by automating trust.

 

“On the face of it, it solves a deep problem in monetary economics: how to establish trust — the essence of money — in a distributed network,” said Andy Haldane, chief economist at the Bank of England, in a recent speech.

An algorithm allows a digital asset to be traded electronically without a central ledger, and its data are connected to, and verified by, previous blocks on the chain.

Proponents say it could speed up slow and inefficient back office settlements, reduce the amount of collateral held up in the financial system, cut transaction costs and potentially remove middlemen — the clearing and settlement houses. For capital markets it is, as Mr Medcraft acknowledges, “a potential game changer. It could also create private markets.”
 

Banks, exchanges and clearing houses, as well as their regulators, are busy exploring the potential impacts. Aite, a consultancy, estimates capital market spending on blockchain technology could soar from $30m last year to $400m in 2019.

The main problem with the blockchain has been trying to find a product on to which it can be harnessed, with the search exacerbated by a lack of common industry standards. As Mr Haldane noted: “Whether a variant of this technology could support central bank-issued digital currency is very much an open question.”

Whether that is merely a modern version of alchemy remains to be seen. For now exchanges and regulators must use more traditional methods to build trust and iron out market imperfections.