Slide 1

Michael Mainelli, The Z/Yen Group

[A version of this article originally appeared in "All Too Visible Hands: Liquidity versus Transparency on Exchanges", Balance Sheet, The Michael Mainelli Column, Volume 11, Number 4, (November 2003) pages 65-67.]  

Exchanging Places

Providing liquidity is an over-riding objective for an exchange.  Without liquidity, there is little point for people to use an exchange - they would soon be frustrated at not being able to trade in volume at the published prices.  Ensuring transparency is an increasingly important objective for exchange regulators.  Without transparency, it is difficult to ensure that some market participants are not getting favoured treatment.  At times, both objectives seem to conflict.  Market participants tend to react strongly against suggestions for more regulator-imposed transparency with dire warnings of reduced liquidity.  Regulators are sympathetic, for instance regulators permit less transparency (reductions in reporting requirements) for "less liquid" trades.  Given some strong recommendations on transparency, it is no surprise that the European Union's proposal for an upgrade to the 1993 Investment Services Directive (ISD) has attracted great interest among market participants and regulators as it advances towards likely implementation in 2004.  Much of the ISD proposal is welcome, however, one assumption at the core of the ISD, that standardisation of pre-trade and post-trade transparency is desirable, is worth further examination.

Financial exchanges seem to entrance governments as few other markets.  Governments evaluate the health of their economies on the scale and direction of financial exchange trading.  Governments fund significant numbers of regulatory bodies with significant budgets.  At the national, supra-national and international level, discussion on exchanges, "level playing fields" in financial markets or standards in reporting kicks off intense inter-governmental discussion and lobbying.  Some types of exchange seem to be particularly entrancing, for instance equity exchanges, while governments almost ignore others, such as foreign exchange trading.  Government interest in the state of financial exchanges is understandable.  Confidence in exchange prices feeds through to confidence in decisions throughout the economy.  Consumer confidence in well-regulated exchanges leads to appropriate investment.

Government regulation is increasingly complicated.  International competition among exchanges is fierce; international standards and standards bodies affect domestic markets; domestic regulators increasingly find that funds flow globally and regulation seems to need to follow; previously "mutual" exchanges are increasingly "for profit"; technology has blurred the definition of an exchange; matching, clearing and settlement are increasingly mixed functions; electronic communication networks (ECNs) and alternative trading systems (ATSs) and multi-lateral trading facilities (MTFs) proliferate.  Governments and exchanges want to create sufficient transparency so that end investors feel the market is fair and attractive to them.  One of the core regulatory functions is increasingly assumed to be to dictate the amount of disclosure required on a financial exchange.

But exchanges are not neophytes about disclosure.  There is a balancing act for an exchange in ensuring that it is seen to provide the best price, yet at the same time ensuring that the incentives to trade "off exchange" are minimised by rewarding members that act as principal risk takers sufficiently to encourage them to do so in future.  Much of this balancing teeters on the issues of legitimate asymmetric information and the rights and responsibilities of market participants to share information.

Perhaps some of the government interest is obsessive - a bit like a hypochondriac wandering around with an ECG machine and jumping with anxiety at every heart murmur.  The tension for government regulation of financial exchanges, as with all government regulation of markets, is finding a position between the ruin of neglect and death from over-attention.

Visible Virtues

Regulators have no monopoly on fundamentalist fervour about the importance of trade publication.  Market participants favour many types of disclosure.  Academic studies indicate that certain types of disclosure may improve market efficiency.  Consumers and businesses like to have a firm price.  There are sensible debates about the amount of post-trade disclosure (how much, how long delayed, how detailed, how anonymous) and the amount of pre-trade disclosure (bid/offer, quantities).

Large trades contain potentially valuable information about the likely price movements of the instrument being traded.  Complete transparency is believed to harm liquidity, i.e. market makers will be loathe to provide risk capital to support trading if all of their moves must be published in advance.  Typical market participant responses to inconvenient or costly regulatory disclosure requirements are to move "off exchange", move "off shore", "cross" trades, create segregated "professional" exchanges or plead for exemptions.  Almost by definition, there are more likely to be larger price-moving trades in smaller shares, so one of the key problems is that smaller shares are more likely to be traded on alternative exchanges.

Exchanges are crucial to "price discovery", i.e. helping market participants establish the value of a trade.  Many "off exchange" responses to publication requirements depend on a reference price being provided by an exchange.  Some people consider these "off exchange" trades parasitical.  It's a bit like agreeing to sell your home to a friend where both of you rely on other published home sales, but don't publish the price of your own to help future buyers and sellers.  Crossing networks are a good example of these types of confidential transactions in equity and bond markets.  Again, smaller shares seem to have a greater propensity to be traded on alternative systems and become less visible.  One common method for increasing the liquidity of smaller shares on is to focus demand and supply by restricting trading time on ATSs, e.g. once a week on ShareMark, or to provide a confidential pricing service as opposed to an exchange, e.g. 535X in the UK giving some helpful visibility to invisible trading.

Regulators and many academics like to promote centralised exchanges that prevent parasitical use of exchange prices by restricting "off exchange" trades or protecting exchanges competitively through barriers to entry or permitting certain monopolistic advantages to exchanges.  Naturally, ATSs argue that forcing all trades "on exchange" would raise the cost of trades unnecessarily, e.g. "Transaction Costs - What Every Pension Fund Trustee Should Know", E-Crossnet, Art of Crossing Series, 2002; and that a large proportion of trades can occur on ATSs without degrading price formation.  ATSs argue that the "gaming" which occurs even on anonymous order-driven systems can damage clients.  Nigel Foster, CEO of E-Crossnet, contends "transparency is good, anonymity is better, but confidentiality is best".  A number of suggestions have been made about the extent to which the ISD proposal should try to identify separate categories of "exchange" or treat all financial trading equally.  It is important to note that ATSs have been created for savvy customers in a competitive market who know what they want by way of transparency and liquidity for different types of instruments.

The ISD proposal includes requirements for pre-trade disclosure (bids & offers on quote markets, a portion of the order book on order-driven systems) and post-trade disclosure (price, volume, time).  The aim of the disclosure requirements is to promote competition.  Alongside a requirement for investment services providers to seek "best execution" (a combination of price, timing, size and other factors) for clients, the disclosure requirements are intended to help providers gain the information they need to provide best execution.

The ISD proposal recognises that large or illiquid trades may be exempted from pre-trade disclosure and granted deferred post-trade disclosure.  However, in practice, it is very difficult to identify large or illiquid trades.  The basic idea is often that there is a "normal market size" above which the size of the trade may move prices on its own.  The London Stock Exchange currently sets normal market size at 2.5% of the average daily number of shares traded during the 12 months.  Customer trades greater than six times normal market size (15% of average daily volume) begin to be eligible for some trade publication exemptions.  Yet numerous studies on many exchanges have failed to prove conclusively one way or the other that normal market size can be predicted for any particular share.  It almost seems that the best predictor is a trader's nose - traders seem to be able to sense what constitutes a market-moving trade, but agree that it varies substantially from day to day, security by security.

Mano a Mano

The ISD proposal has generated comments from a number of quarters.  The European Central Bank issued an opinion on 12 June 2003 that, among other things, pointed out its support for an effective transparency regime.  The opinion pushed for wider application of transparency, including extending the regime to all trading (not just "on exchange"), consolidating price information across the EU, requiring debt securities to conform to publication requirements, and restricting publication exemptions.  On the other hand, there are strong mutterings, at least in London, that the ISD proposal could result in the end of sales trading.

Despite looking in detail at economic studies, and with some admiration to the USA's liquid markets, European regulators are in danger of confusing cause and effect.  Transparency comes from competition, not from regulation.  Trade transparency is a competitive position chosen by exchanges seeking to attract customers with a level of open-disclosure and risk-taking traders with a level of non-disclosure.  "Invisible" trading is merely a competitive position.

"In no trading system are all these categories of price and quote information published.  Indeed, the strategic non-disclosure of some types of price and quote information is a central element of all market architectures." [Ruben Lee, What is an Exchange?, Oxford University Press, 1998, page 98]

Trade transparency frameworks evolved as exchanges competed with each other.  In the absence of competition in some national markets (competition often abolished by national regulators themselves), regulators are more responsible for imposing transparency regimes.  It is true that regulatory pressure has encouraged exchanges in competitive markets to be more open, but there has always been a commercial interest to do so as well.

So what's a poor regulator to do?

"While the SEC must promote efficiency, innovation and competition in the securities markets and among market participants, we should not and do not dictate ultimately which specific market structure serves investors best.  Rather, competitive forces will determine which markets should fail or flourish, sink or swim in today's economy."

[Remarks by Commissioner Laura S.  Unger, "Trading Floors Versus Computer Networks", U.S.  Securities & Exchange Commission, Panel Discussion, Davos, Switzerland, 29 January 2001]

In the large European market, there is no reason that competition should not result in appropriate trade transparency, so the ISD proposal could be improved by not requiring any trade publication.  Competition across Europe will produce appropriate transparency, balancing liquidity with consumer protection.  Invisible trading may be better for some instruments' liquidity and price than total visibility.  Different degrees of translucence and opacity work are needed for different instruments.  For instance, it is difficult to see how customers would be attracted to a completely opaque exchange.  Without the ability to test prices and capacities, they would migrate to a more open exchange.  At the same time, totally transparent exchanges would not attract sufficient liquidity and would have to arrive at some exemptions for risk capital providers.

This is not to be complacent about protecting consumers.  What the ISD could propose is that exchanges be forced to disclose their publication regimes, and that regulators are forced to audit that exchanges adhere to their stated regimes.  By disclosing their terms of trade publication, exchanges are specifying an important aspect of their product.  Naturally, they should be sternly held to account if their statements about their publication requirements differ from their actions.  Exchanges need to have enforcement mechanisms and regulators need to have enforcement mechanisms for exchange enforcement.

We have tried, but it is almost impossible to talk about transparency and liquidity in isolation.  They are complex topics with complex inter-relationships to other economic, regulatory and international financial issues.  The ISD proposal is largely welcome - particularly as it is intended to promote increased competition among European exchanges.  Nevertheless, over-standardisation of trade transparency strikes at the heart of exchange competitiveness.  It needn't.  We need regulators who ensure exchanges do what they say on trade publication, not regulators who say what exchanges must publish.

The author would like to thank all of the people who contributed to the research behind this column, in particular Christopher Prior-Willeard, who urged him to explore the advantages of "invisible trading".


Michael Mainelli, FCCA, originally did aerospace and computing research, before stooping to finance.  Michael was a partner in a large international accountancy practice for seven years before a spell as Corporate Development Director of Europe's largest R&D organisation, the UK's Defence Evaluation and Research Agency, and becoming a director of Z/Yen.

Michael's humorous risk/reward management novel, "Clean Business Cuisine: Now and Z/Yen", written with Ian Harris, was published in 2000; it was a Sunday Times Book of the Week and even Accountancy Age described it as "surprisingly funny considering it is written by a couple of accountants".

Z/Yen Limited is a risk/reward management firm working to improve business performance through better decisions.  Z/Yen undertakes strategy, finance, systems, marketing and organisational projects in a wide variety of fields, such as recent projects developing a risk/reward prediction engine or benchmarking transaction costs across global investment banks.