Is exchange consolidation desirable for global markets?

Is exchange consolidation desirable for global markets?

The CEO of Deutsche Börse made some very interesting remarks at the recent IDX derivatives industry conference in London. He argued that the proposed merger between Deutsche Börse and LSE would aid the development of trading in global markets because it would unite and harmonize the European capital markets, which are more fragmented than those in the US and Asia according to him. However, in this author's view, the merger of two large global exchanges raises as many questions as it answers. While one can agree that there would be less fragmentation and more harmonization, the main issue is whether the European market has a high level of fragmentation when compared with its global counterparts. Due to the European Union, European capital markets are much less fragmented than the Asia-Pacific, Middle-East and Africa, and Latin America. There has been a great degree of harmonization over the years, driven both by common regulation and industry mergers & takeovers. It is difficult to argue that there is a pressing need for more integration at this point. Instead, the main argument for the merger of LSE and Deutsche Börse is the fact that it would create a larger exchange that would be able to take on the likes of CME, Nasdaq and some of the leading Asian exchanges more easily. The expected reduction in headcount would also make for a more efficient, streamlined, and competitive exchange. But there are concerns that remain from an antitrust point of view and it is quite likely the Deutsche Börse CEO was trying to assuage these when he spoke about the positive effect of such a merger on global markets. If the merger does go ahead with regulatory approval, the advantage for other leading exchanges would be the higher possibility of such mergers and takeovers being approved in the future as well, since these could well be expected in an industry that is undergoing heavy consolidation due to economic and technological factors.

Moving towards a more stable and healthier OTC derivatives market

Moving towards a more stable and healthier OTC derivatives market

The Bank for International Settlements (BIS) recently reported that there was a decline in the cost of replacing outstanding OTC derivatives, the first since the financial crisis. There was a similar decline in the gross notional amount outstanding as well. While this indicates the tough regulatory regimes worldwide in the aftermath of the crisis, it also a sign of a healthier and more resilient OTC derivatives market. Due to the rising regulation-related costs of trading, market participants are looking to make their OTC derivatives trading more efficient. Tools such as trade compression and collateral optimization are being used for this purpose. So the decline in outstanding is also an indication of more efficient trading due to compression. Another sign of the efforts to reduce systemic risk is the rise in volumes of OTC derivatives that are being centrally cleared. The greater use of clearing houses is something that regulators have been espousing for some time, and an approach that most market participants and observers agree with. Besides the internal factors, external economic ones such as interest rates and exchange rates also explain some of the decline in value of OTC derviatives trading. Again, these are a sign of market fluctuations and do not necessarily represent any market decline. In our view, the BIS numbers are indicative of both the changes that regulators have put in place over the last 7-8 years and of a global economy that is still recovering from the financial crisis and the following economic challenges.

Regulators to end ASX’s clearing monopoly

Regulators to end ASX’s clearing monopoly

In an interesting development Australian authorities are looking to end Australian Stock Exchange’s (ASX) monopoly on equity clearing and relaxing ownership restrictions that removes a potential hurdle to the ASX’s participation in overseas mergers. First, some background: Australia for long was like many other Asian markets with a single incumbent national exchange that is vertically integrated carrying out clearing and settlement activity. Departing from other Asian market practices, regulators introduced competition in the local exchange space by allowing a foreign player Chi-X, which entered the market in 2011 and quickly took significant share away from ASX. However, clearing of trades, including those conducted at Chi-X, was still conducted by ASX as it was the only clearing agency in the country.

Chi-X has been complaining for some time that this situation gives ASX unfair advantage and possibly creates conflicts of interest in that Chi-X has to depend on its competitor for clearing of its own trades. They have therefore called for introducing competition in the clearing space to mitigate the situation, bring down clearing fees, and accelerate innovation. ASX has cut clearing fees in the past, and again indicated that it would further cut fees by 10% from July, 2016. It has also argued that the Australian clearing market size is not big enough to make multiple clearing houses viable.

While the new changes indeed pave the way for newer players to enter, whether and when that materializes would be interesting to see. The Financial Times observes that these changes are “unlikely to result in the establishment of a rival clearing house in the near future”, but will “create a regulatory framework that gives competition authorities the power to arbitrate disputes about access by rivals to the ASX’s clearing and settlement services.” It may be noted that competition in the OTC clearing space was introduced a while back and LCH.Clearnet has already entered and captured significant market share. Merger with an overseas player, in spite of the rule changes, may not be easy. In Asia, the issue of national pride associated with national entities such as exchanges is a particularly important factor, and can make mergers and acquisition by foreign entities tricky, as was seen in Singapore Exchange’s failed bid to acquire ASX previously.

ASX on its part has been active in upgrading its technology and systems to stay abreast with international best practices and ahead of potential competition. In some cases it is taking the lead in the industry and looking to build innovative solutions that could transform trade processing operations. It would be interesting to observe how these initiatives shape up and what impact these changes have on the Australian and global exchange landscape.

Symphony messaging: WhatsApp to business’ ears?

Symphony messaging: WhatsApp to business’ ears?
It’s official, what many financial institutions have been saying for quite a while is becoming reality: they don’t want Bloomberg (or any third party?) to have access to all of their messaging, trading or not related, anymore and hence have decided to team up as equal partners, in a top-notch technology utility that serves the needs of its members, a key to its potential success, to fund a competitor messaging system called Symphony. The network, the link between the bankers and their clients and between their clients and their competitors is what enables them to be and stay in business: A third party cannot be invited around that table. Not only, Symphony could be offered to other business sectors as a professional WhatsApp. Follow me here: financial institutions don’t trust anymore a third party to manage their messaging data, but think other business sectors will trust financial institutions to manage their messaging data. Although I personally got annoyed when my bank asked me why I was spending some of my savings‎ on our family farm when I asked for a mortgage, I know they probably know my financial situation better than I do, and that I am not a potentially “good” client for them: I trade myself, have little savings, do everything online, so I guess it’s only fair for them to ask. Of course Big Brother is watching me – and so should he. But I am not sure if I would send all my WhatsApp messages on a bank-owned competitor system, would you run the risk that your bank could potentially see all your messages? In the case of corporations and businesses though, things are slightly different: their relationship with their banks are usually extremely deep, their bank helped them get their first line of credit, maybe introduced them to private investors or helped them IPO. And when they wanted to take part in a big project with a new foreign client they bridged the financing of the project, they helped them offset their FX risk, invest their liquidity and manage their treasury… so if they started potentially seeing their employee’s messages to their clients or suppliers, would it really make a difference to them? Probably not. Of course I am extremely simplifying the potentially extreme risk such a system could have; It has been created on the back of a highly secure encrypted internal system Goldman Sachs had developed and has been enhanced with the best of the best (it is said) technology, in an open source environment. We’ll be make sure to test it as soon as it is offered to the public later this year and am waiting for the next Instagram for finance.

Battle of the messaging systems, and more

Battle of the messaging systems, and more
The introduction of the Symphony messaging service, backed by 15 large banks, should make things interesting in a space that has long been dominated by Bloomberg and to some extent Thomson Reuter’s Eikon. It is another example of cooperation between large banks after the recent introduction of an OTC derivatives collateral management utility, which was discussed in an earlier blog by this author. Banks are increasingly moving onto the turf of players such as Bloomberg and large IT firms involved in the capital markets through such ventures. It is an interesting business models where the buyers of services are coming together to create or back service providers, which would reduce prices of these services, put more competitive pressure on the other service providers in the space and create greater synergies and efficiencies for the industry overall. It does make things a little tougher for regulators, as the traditional boundaries of which firms are the service providers and which ones are the consumers are changing. But overall, it seems to be a positive move for the markets. The rising costs of complying with financial regulations and the tough market environment have possibly been important drivers for banks to cooperate in this manner. Having the backing of large banks in itself does not guarantee success to Symphony. However, its open source platform offers it a strong chance of being a contender in this space, as it allows its users to add their own features to the messaging platform. What would also be interesting for the neutral observer is the reaction of players such as Bloomberg and Thomson Reuters. These have long dominated not just the messaging, but also the terminal space, and now there are efforts to break their stranglehold on this market. These are large technology-oriented firms that offer a wide gamut of services to the banking and capital markets industry. Their response (if any) to the launch of Symphony could give us valuable insights into how they would react if their control of the terminal space is challenged. Interesting times ahead for sure!

Equity market upheaval in China

Equity market upheaval in China
The recent restrictions being placed by the Chinese government on trading in the Chinese market are creating an artificial barrier to the normal and efficient functioning of the market. The equity market is mainly a reflection of the structural economic underpinnings of the economy. If the economy and the firms in it are doing well, then the stock market would also perform well. If not, then it would be normal to expect a downswing in the market. By focusing on the equity market and not on the economy itself, the Chinese government might be ignoring some of the structural weaknesses in its economy that are creating the downward pressures in the markets. Creating an artificial bubble is normally not in anyone’s interest, although an argument might be made that it has become more de riguer after the spate of quantitive easings and similar regulatory interventions in the aftermath of the financial crisis. Another issue that has been pointed out by some observers is that the weighting and role of Chinese stocks in leading global indices also becomes unrepresentative due to such interventions, and the index managers have to then weigh the balance of having such stocks against the imbalance created by having them in the index. Furthermore there is less incentive for the market participants to pick stocks on the basis of firm and industry performance, since the intervention seems to be keeping up the prices of stocks that would otherwise have been expected to not perform as well. Hence, there are several issues that can arise from such an action and it might be in the interest of Chinese regulators and the markets as a whole to reduce the level of intervention.

A vital utility in the OTC derivatives industry

A vital utility in the OTC derivatives industry
Leading OTC derivatives industry participants including banks and post-trade services providers are backing the creation of an creating an OTC post-trade infrastructure utility. This hub will help automate the margin management in the industry and is also expected to reduce the disputes around margining. Until recently, moving important functions to utilities was often frowned upon. In several instances, firms showed reluctance to participate in a utility unless there was evidence of widespread acceptance of its services. But now factors such as regulatory requirements and the need to cut down upon costs are creating an environment conducive for the greater acceptance and use of utilities. To that extent, the industry has reached the tipping point with several other instances of utility or near-utility services being offered, most notably for KYC requirements. This is a good sign for the industry overall. The higher cost of operation due to regulatory requirements and the ever-growing need for investment into technology up-gradation means that often it might make more sense to move such services that are either more commoditized or require industry cooperation (or both) onto a utility platform. Hence, such a step in the highly competitive OTC derivatives industry is quite significant. It will help increase automation and efficiency, reduce costs, and encourage other segments in the capital markets industry to consider the use of utilities in a more positive manner.

Looking beyond ‘Bondification’

Looking beyond ‘Bondification’
There has been an interesting article in the Financial Times by John Authers on the ‘bondification” of the equity markets, namely the tendency for fund managers to invest in good dividends, low debt and high return on equity. Some of the causes of this phenomenon include the low interest rate regime in many of the mature markets such as the US and the tendency for high risk aversion after the financial crisis. Authers also quotes a move away from traditional finance theory as comparing returns with the risk-free rate does not always work given the issues in defining what a risk-free rate is in the current fixed income market landscape. He also mentions issues fund managers have with risk diversification since it did not seem to work in the financial crisis for commodities or emerging market equities. The author concludes by saying that the bondification of risk might not necessarily be desirable in the long run. I agree broadly with the conclusions of the author but would also like to point out some relevant issues in this context. The first is that the low interest rate environment will not stay forever, hence the market is going to move away from the tendency for bondification and this would benefit both fixed income and equity markets. The fixed income markets would see more activity and the equity markets would be able to get out of the constraints that bondification places on it, including investment into mainly blue chip stocks which would be popular anyway and away from less established or riskier stocks of smaller firms. The second issue is regarding the falling relevance of the investment models, namely the use of the risk-free rate and falling tendency for risk diversification. Just because there was a financial crisis does not mean that financial theory or models become less relevant. The issue was less with the models and more with the practice and issues in the economic, business and political environment. The use of a risk-free rate might still be of relevance, it might just have to be calculated more carefully and using a set of return indicators instead of certain benchmark bonds. Similarly, risk diversification is still as relevant as it was before the crisis. With the lessons from the crisis, our approach can become more sophisticated and complex, but we cannot stop using diversification just because it might have failed in the financial crisis, which was (hopefully) a once in a lifetime phenomenon. It should work as long as there is no crisis of similar proportions.

Is the Saudi Arabian equity market the last emerging market frontier?

Is the Saudi Arabian equity market the last emerging market frontier?
The Saudi Arabian equity market, the Tadawul, has recently begun  the process of easing access for foreign investors. A late entrant on the global equity scene, the market itself is not something to be scoffed at, being larger than the likes of the Mexican, Russian, and Indonesian equity markets in terms of market capitalization. And this is without the Saudi oil firms, which are state-owned. However, there are some significant restrictions on foreign investment such as limits on the minimum asset size a firm should have, the percentage a foreign investor can own in any one stock, and the T+0 settlement period which is a challenge for any foreign investor. The opening up has been a gradual process. Some investors such as HSBC have shown their hand by moving early, but most leading global investors seem to be taking a wait and see approach. Also, some foreign institutional investors are in the process of completing their application for the Qualified Foreign Investor license. So while it will be some time before the Tadawul becomes as important as some of its other emerging market counterparts in the international context, it seems to fit the bill of the last frontier for global investors among the large emerging markets. A possible bright spot for an asset class that has been under the weather of late..

Nasdaq’s vision for Blockchain

Nasdaq’s vision for Blockchain
Nasdaq has recently one become of the first leading capital market firms to consider the use of Blockchain and Bitcoin technology. It plans to use the technology in its private markets platform to begin with, with the possibility of using it in its clearing houses and CSDs at a later date. In some ways, this is the most significant commitment any large financial market firm has made to adopting Blockchain. Even more interesting is the manner in which Nasdaq has gone about the process. It has made one of its VPs an evangelist of the platform, with a strategic mandate. This is an interesting example of a tech-savvy firm utilizing an innovative approach to encourage and advocate for what it sees as the next big wave of change in the financial markets. However, the open architecture of Blockchain technology and the difficulty in controlling the kind of transactions that could happen through it make it complex to use, and there are some resultant security concerns as well, which is why large banks are normally reluctant to adopt such a technology. So the industry would have to put checks in place before there can be widespread adoption of Blockchain in capital markets. There are already some existing provisions with Blockchain to address these requirements, and we can expect more effort in this regard as time goes on.