Issue #7
March 2002
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Challenges to Our Financial Markets by David Katz The structure and operation of both commodities and equities markets are facing major challenges. At this month's Futures Industry Association conference in Boca Raton, these challenges were the subject of every panel and speaker.
Four major processes are driving the changes that are underway. These are demutualization, the expansion of electronic markets, the convergence of previously separate markets into a single, overlapping trading environment, and globalization of markets.
Demutualization is the process of converting exchanges from member-owned associations to for-profit corporations. Many of the newer exchanges, formed in the last five or ten years, began life as corporations, but the traditional commodities exchanges such as the Chicago Board of Trade, the New York Mercantile Exchange or London's LME, have a long history as membership organizations.
The advantages of demutualizing are easy to state; the disadvantages are harder to quantify. The foremost advantage is access to capital. Membership organizations must either assess their membership for the funds needed for expansion and modernization; sell additional seats, diluting the value of existing seats and the internal power of their owners; or increase the fees charged for each transaction on the exchange. As a corporation, development funds can be raised by stock offerings or debt financing.
A second advantage is the ability to effect change more rapidly. Membership organizations, by their nature, are government by committee and are slow the reach decisions. In addition, the diverse interests of the members sometimes results in deadlock and inaction. Corporations are less democratic, and with a strong CEO can embrace rapid change more easily.
The disadvantages of demutualization are more subtle. As federally regulated membership organizations, the exchanges had clear responsibilities to their members, their industry, the economy and the public at large. As regulated corporations, some of the responsibilities toward the general public will remain, but as time goes on and the shareholdings by current members become diluted by stock purchases of non-industry members, the focus inexorably will shift from promoting member and industry interests to improving the bottom line, with as-yet unknown negative effects. As membership organizations, the operating management of the exchanges was directly answerable to the membership; as corporations, the exchange management will become autonomous. No major US corporation is actually under the control of its shareholders; at best, shifting alliances of major stockholders and senior management provide some brake on the untrammeled exercise of executive power.
Technology, in the form of enhanced communications and electronic trading, has already modified the traditional trading world. Electronic trading makes possible 24-hour markets, enhanced price disclosure, the ability to trade a wider range of more complicated instruments with fewer traders and support personnel, and more rapid trade execution. It also loses some of the market information inherent in person-to-person interaction, and threatens disintermediation as the traditional order-placing and execution roles of the broker now can be done directly by the trader and electronic exchange. While clearing brokers are not in danger of disintermediation, the executing broker, floor broker and local (a broker on the exchange floor, trading for himself, who adds liquidity to the market) are. Locals (and market-makers on the equities exchanges) may well lose some of the advantages that their floor placement gave them. Futures and equities markets are not the only ones affected. As more and more physical goods are traded using some sort of electronic intermediary, whether the private system of some major industry player or a public system sponsored by an exchange, the same issues present themselves.
The various exchanges have reacted to this tension between person-to-person trading and electronic trading. Some have added electronic trading of the same instruments traded on their floors (usually after hours or in mini-contract sizes), some have restricted electronic trading to new product areas, and some have formed alliances with electronic exchanges in which clearing is shared and margining allows for offsetting of electronic and non-electronic contracts. The future of pit (floor) trading is shaky, but it will probably survive in those markets where tradition and product suitability support it. The future of electronic trading is not in doubt: it will grow.
Market convergence is the least widely reported, least well-understood and potentially most far-reaching of the changes. Stock indexes and single-stock futures have pierced the equities/futures barrier. Physicals clearing arrangements being negotiated with futures exchange clearing organizations have blurred the physicals/futures divide. The old watertight compartments that separated stocks from futures from physical commodities are now so leaky that even Leo Melamed, Chairman Emeritus of the Chicago Mercantile Exchange and a pioneer of innovation in the commodities industry, thinks that in a few years referring to the futures markets will be meaningless; all the markets will be so intertwined that futures, forwards, equities and various market derivatives will be used by individual traders to achieve specific ends. Specialization will no longer be by where the trading takes place, but by the purpose and characteristics of what is traded. Electronic trading is helping this process along: a single trader, staring at a computer screen, can follow simultaneously what used to be separate markets handled by separate traders, and look for the greatest advantage across markets.
Finally, globalization of markets, a process underway for several decades now, has reached the point where nations no longer really control the flow of capital into and out of their economies. Indeed, to speak of economies in the plural is no longer possible. The market mechanisms: exchanges, regulatory agencies, traders and investors, are all reaching accommodations to suite the new situations they find themselves in. Exchanges have been making alliances with those of other nations for trading and clearing selected products; several of the newer exchanges are truly international in nature (for example, NQLX, formed to handle single-stock futures, is an offshoot of America's NASDAQ and Britain's LIFFE); and traders can now move money or acquire goods 24 hours per day in whatever part of the world offers them the best deal.
Globalization of markets is not without its risks, though. The kind of strong regulatory oversight that guarantees honest markets in the US and Europe is not available everywhere in the world; dictatorships and nations in chaos present a clear risk that their rules may be changed at any moment.
The financial world of today would have been an incomprehensible vision to a financial industry player of 1970. The financial world of 2030 may well be unforeseeable by us today.
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