“The post-election crisis which nobody is seeing”

The Financial Services Authority’s (“FSA”) control over Britain’s capital markets is under a threat which vitually nobody is seeing. It is about the Markets in Financial Instruments Directive (“Mifid”) and multilateral trading facilities (“MTFs”).

In March 2010 the London Stock Exchange (“LSE”), for the first time, accounted for less than 50% of trading in FTSE 100 stocks. The other 50% went through MTFs.

This, potentially, drives a coach and horses through open transparency which is the king pin on which the control of market abuse hangs.

Mifid is allowing the fragmentation of trading. It enables MTFs, by offering lowering trading costs, to prosper. The LSE is fighting a frantic battle against rivals such as Chi-X Europe which offers trading in shares across 14 European markets. In the US, equity markets are splitting, between the NYSE and Nasdaq and smaller rivals such as BATS and Direct Edge.

The risk lies in the inability of MTFs, as one example, to survey bid and offer prices and executed trades. The other risk is that this mitigates against the concept of the primary market, where there is a single price discovery market allowing effective regulatory control.

The FSA control the markets…or not, as is now happening. It is an open invitation for market chaos. It could lead to a crisis of confidence which might derail capital raising globally.

Among the main possible abuses are:

Dark Pools
These allow financial institutions to execute big equity orders ‘over the counter’ thus concealing the trades from the public markets. Thus the trade will not affect the quoted price. There is an argument that they add to market liquidity. NYSE Euronext, through its SmartPool system, executed one billion of euro trades in January – March 2010, double the last quarter of 2009. In the US dark pools are thought to account for around 8% of trades.

An additional feature is that the use by operators of computer based trading systems means deal sizes are falling making the monitoring by regulators even more difficult.

Front-running
This is where a broker, knowing there is a large client order to be executed, will buy or short sell on his own account.

Layering (aka spoofing)
This involves placing a spoof order on an exchange and benefiting from a possible price movement.

The problem initially rests with Brussels and the Committee of European Securities Regulators. In practice the FSA must be monitoring it.

Every economic cycle has its own characteristic. In the late 1990s it was the internet market boom, in the middle 2000s it was ‘sub-prime and credit derivatives’.

Brokers and financial investment businesses are profit driven. Short selling is a market technique. Morality is for the politicians.

As the cycle moves towards its next bull market phase and investor cash hits the bourses (just wait until the Chinese private investor is allowed to invest in Hong Kong) the threat of market abuse grows daily.

If I were the FSA I would vote for George Osborne and shift the responsibility for market supervision to the Governor of the Bank of England as fast as I can.

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