University of Cambridge, Centre for Corporate and Commercial Law:
The challenges facing financial regulation, July 6-7, 2000
Gay Wisbey, Director, Markets & Exchanges Division, FSA

The title we have been given for this session is potentially enormously broad. But the fact that all of the speakers on this panel come from what we, at the FSA, would call traded markets means that our focus this morning is essentially securities and derivatives markets.

The impact of technology on markets

It’s refreshing to come to a conference where not all the audience are that closely involved in the day-to-day running of markets. These days you often find yourself speaking about technology and markets at seminars and conferences when you know that a good part of the audience are probably busy devising the next piece of technological wizardry. On those occasions, you just hope that you’re only nano seconds off the pace, rather than light years.

This morning I suspect that the information asymmetries between speaker and audience are rather different. I’m not a lawyer! Now whether or not that should make me any more confident about talking about technology, time will tell. But I thought that it would probably be helpful for our exploration of the regulatory issues if I spent the first couple of minutes outlining some of the main ways in which technological advance is driving change in the markets. After that, I will move on to the issues and challenges that this means for my own division at the FSA, and how we are addressing them.

From a market viewpoint, the three most important characteristics of modern technology are: firstly, its ability to process huge quantities of information; secondly, its ability to link multiple providers and receivers of information anywhere in the world; and, thirdly, its capacity to perform both these functions at mind-numbing speeds. The broad effects of this are to make it technologically possible to have very large, very complex markets, and for those markets to operate - at least in a technological sense - out of black boxes located anywhere in the world. And increasingly, of course, that is precisely what is happening. Because, in a nutshell, it is far more efficient than the old market process, and it opens up new business opportunities.

So how is all this impacting on markets at a more micro level? Well, let’s take a quick walk down the transaction chain. At the head of the chain, we have the ultimate users of the markets - the investors. Technology is changing their lives by putting them on-line. Whether they are private investors or institutional investors, they now have access to huge amounts of market information, and they can control their own order instructions. As today’s jargon has it, they are empowered. And there is no doubt that this has been one of the major factors behind the huge growth in market volumes in recent years and, some would argue, also the increasing volatility in many markets.

Next we come to the heart of the market process - the operations which match buying and selling interests. The most visible development here is that trading floors – along with brightly coloured jackets, perpetual shouting and mystifying hand signals - are on the way out. None of London’s three securities exchanges any longer has a trading floor. Nor do either of the two financial derivatives exchanges. Only the London Metal Exchange and International Petroleum Exchange retain trading floors - and both of them are now working on plans to introduce some element of electronic trading to their markets. Why has technology driven out floors? Quite simply because the operating costs don’t compare. A mainframe computer occupies the equivalent of only a corner of most exchange floors; it does not need to be located in a prime location; it can handle far more transactions than a floor; and intelligent software can do much of the market monitoring that may previously have been done by bevies of pit observers.

The only real surprise perhaps, is that the process of abandoning physical trading floors is taking so long. I’m sure Mary Schapiro will have something to say about the relative lack of speed of many US markets in closing their floors – though NASDAQ, of course, was way ahead of the game by never having one in the first place. There are, I think, two main reasons for this. One is that some markets probably translate more readily to screen trading than others. But the main reason is the powerful resistance by those interests – especially in exchanges less vulnerable to competition - which are likely to be losers rather than winners from market modernisation.

So what is replacing the physical floor? Answer, the market in a black box. And what are the consequences of that? Markets that can offer participation to far more people – and potentially a much wider range of people - than you could ever squeeze into a pit or on to a floor; markets that can have remote members anywhere in the world; markets where the legal, marketing and regulatory operations can be jurisdictionally separated from the market technology; markets that can use computing power to offer greater variety and complexity of trading algorithms; markets that can be replicated, and competed with, much more cheaply than in the past; markets that can potentially use their technology to develop a whole new range of business opportunities.

So much for the core operation of the market. The third leg of the transaction chain is clearing and settlement. Here, many of the benefits of new technology have still to be realised, especially in Europe. But they will come. In due course, straight through processing will complete the seamless electronic transaction. By progressively removing paper from the transaction process this will both improve accuracy and greatly reduce the risks that can build the longer the time-span gets between trade time and settlement date.

To summarise, technology is facilitating radical change in the operation and structure of markets, in roles and relationships among service providers, intermediaries and investors, and in the very scope of markets. But while it may be the march towards the truly global market place that catches the imagination, of greater importance to most market users is simply the application of technology to enhance general market efficiency.

Issues for regulators

So what issues do all these changes pose for regulators? I could do a re-run through the transaction chain because there’s no shortage of issues all the way down it. But I think it is probably better to take a step back and focus on a few of the more generic issues. I have picked the following four headings - some of them inter-related - and will make a few points on each. They cover :

Regulatory organisation

Functionality and fragmentation

Access and participation

Technological dependence

These are all issues that are currently proving very challenging for market regulators everywhere. The US, in particular, has been working on many of these issues for a number of years now. This has resulted in initiatives such as Regulation ATS, published last year, and the recent SEC consultation on market fragmentation.

At the FSA, we also have been giving a considerable amount of thought to these issues. Earlier this year we published a Discussion Paper entitled ‘The FSA’s approach to the regulation of the market infrastructure’. We had 36 responses to the Discussion Paper and we are currently mulling over those responses and considering what, if anything, we want to do next. I’ll come back to that a little later. First, I want to make a few points about each of the four issues I mentioned.

Regulatory organisation

First, regulatory organisation. Here, there are two fundamental issues on the regulatory plate. Number one flows from the way in which technology has opened up a largely static business model in the exchange markets and unleashed competitive forces of what, I think, can justifiably be called seismic proportions. It’s not just a case of exchange versus exchange, or longer-established exchanges versus the upstart exchanges; it is also exchanges in competition with new trading platforms, very often run by their members.

As I explained earlier, to obtain the commercial flexibility required to survive in this competitive world, many exchanges have demutualised and turned themselves into ‘for profit’ organisations. But, does this new commercial imperative create conflicts of interest that should preclude them from continuing to hold either some or all of their regulatory responsibilities? Some argue that it does. Others argue that, on the contrary, commercial pressures will tend to reinforce regulatory rectitude, not undermine it. Yet others argue that regulators should treat today’s exchanges like any other commercial organisations and simply forget about any concept of public interest or utility beyond the normal considerations of competition.

In the UK, we don't take the view that demutualised exchanges are automatically unsuited to regulatory responsibilities. It is true that the government decided to transfer the UK listing authority from the London Stock Exchange to the FSA following the LSE's recent decision to demutualise. But that decision was probably influenced by other considerations too, notably the appropriateness of leaving the listing authority under the auspices of the leading exchange when new, competing exchanges were starting to emerge and might well have considered the arrangement to confer an unfair advantage.

It is, perhaps, too early to assess how exchanges will respond as competition intensifies. But, for the moment we remain of the view that 'for profit' exchanges can continue to play a front-line regulatory role in terms of ensuring the fairness, efficiency and safety of their markets, provided that these regulatory functions are underpinned by appropriate governance arrangements. The really interesting question looking forward is, perhaps, whether some exchanges may start to change their view that a high standard of market regulation is a competitive advantage and start to view it instead as an overhead that is better contracted out or passed to the mainstream regulator.

There are a multitude of other interesting issues in this area, particularly relating to ownership of exchanges and the admission to trading by exchanges of their own shares, and if you wish we can return to those in our discussion session.

My second point in the context of regulatory organisation relates to the consequences of technology facilitating the internationalisation of markets. There are a fistful of issues here, but in the end they all come back to one question: how do you regulate such markets effectively?

How does an exchange with remote foreign members enforce its rules? What problems may arise in a case of default given different insolvency laws? What do exchanges with extensive regulatory responsibilites for member supervision do when many of their members are primarily subject to the regulators in their home state? Above all, perhaps, how does a market, a market authority or a criminal prosecuting authority enforce provisions against market abuse in cases when large numbers of market members and investors are resident in other countries?

At present we're quickly moving ourselves up the learning curve. Remote membership is a growing phenomenon and we need to devise ways of ensuring that regulation works effectively across borders. This will probably take a mix of co-operation, information sharing and, maybe, even some agreements to carve up regulatory responsiblities if this should seem appropriate.

Functionality and fragmentation

My second batch of issues focuses on two key changes in the markets themselves: functionality and fragmentation. Arguably, most exchanges do rather more now than simply provide a venue for their members to trade. Their new cyber trading floors contain the algorithms for order execution, and the exchange facility conducts the order execution. In this sense, exchanges are moving a step closer to brokerage. At the same time, brokers too are adopting various types of order-matching and automated dealing facilities. In short, many of these organisations provide broadly common functionality. Yet they live in different regulatory boxes. In the case of exchanges, the regulatory focus is on the regulation of the market – all of the aspects that go towards a fair and orderly market; while in the case of the broker, regulation does not concern itself with the market per se but rather with a firm's conduct of business in respect of its customers.

In our discussion paper, we floated the idea that entities providing similar functionality should be regulated in a broadly similar way. The majority of respondents were supportive of this approach - though with the proviso that we should also distinguish between wholesale and retail markets.

My second issue in this section relates to the flipside of more competition in the provision of trading platforms – the potential fragmentation of liquidity. I don’t think anyone disagrees that competition is, for the most part, healthy. But as regulators we do have concerns that competition should not take place in a way that distorts the fairness, efficiency or safety of the market overall. The more transparency and access provided by systems, the less those concerns are likely to be.

Nonetheless, we do face a need to ensure that minimum standards are sufficiently high to remove concerns about any competitive 'race to the bottom', internationally as well as domestically. Secondly, we need to feel confident that the quality of price formation is not diluted or otherwise diminished, and that we have a demanding yet realistic policy on best execution. Whether or not we need to promote some form of virtual order-book for the whole market or a consolidated tape of completed trades remains to be seen. Our preference is always to let the market devise its own solutions wherever possible. But if the market fails to deliver adequate and effective solutions, then we would be bound to think further.

Access and paticipation

My third batch of issues relate to access and participation. A key aspect of technology is the way in which it opens up access in that just about anyone can access a market; and, conversely, market operators can provide, or arrange, connections to their markets to just about anyone, anywhere. Let me offer you just three issues for starters.

First, cross-border access – on what basis should markets be free to sign up trading participants wherever they want, without unreasonable obstacles, delays or costs on the part of regulators? A difficult issue, given regulation's essentially national basis, but one where regulators will need to make more progress, both by ensuring there is continuing convergence of regulatory standards and by building more mutual trust and co-operation.

Second, there is the issue of direct access to trading platforms without broker intermediation. In other words, the potential ending of broker/dealer control as gatekeepers to the market. So far, it’s happening mainly at the institutional/ professional/ corporate levels, which seems to me to be fair enough, provided the arrangements are prudent. Much talk of direct retail access on the other hand is, I think, rather misleading. Retail investors are certainly playing a greater part in many markets (especially equity markets) and many on-line investors have the opportunity to see real-time prices and execute against them. But even in the US they are by and large still dealing on ECNs via a broker, however invisible that broker may be.

My third point is where intermediaries provide their more favoured clients with look-through facilities that enable them to place orders direct on the order-book. Just how good are the various filters that firms are putting in when empowering clients to trade in their name? So far, I think, so good, but it’s an area that makes me feel slightly uneasy, not least because one hears anecdotal evidence of the filters being switched off for some clients.

Technology dependence

Finally, then, I come to the increasing use of, and dependence, on modern technology and electronic systems. Technology increases efficiency; technology opens up new business opportunities; technology expands consumer choice and consumer power. But, at the same time, the whole market system becomes hugely dependent on the quality of the technological infrastructure. Is security adequate? Can systems deliver what they promise? Do people have access to what transpires inside the black box as much as they need to? What happens when systems, especially systemically key systems, go wrong or fall over?

Is this an area where commercial forces can be relied on sufficiently to ensure that problems do not arise? Or is there a need for regulators to take an interest and try to add value by promoting minimum standards/good practice in areas identified as vulnerable? This was another issue on which we sought views in our January discussion paper. I think we were slightly surprised at the response. Our expectation had been that most market participants and market service providers would say ‘hands off’. And that is precisely what roughly half of those who sent us responses did. But there were also a good number who thought that this was an area in which it was proper for regulators to take an interest.

The last thing regulators want to do, of course, is to get involved in the specific technology per se, in setting specific technology standards – such as what bandwidth should be used for a network - or making judgement about the technical quality of technology providers. But I do think that we have an interest in ensuring that we pay sufficient attention to the management of technology, whether that technology is provided in-house or through outsourcing arrangements. That seems to me to be not only a legitimate but also an important part of our general oversight of management, whether of firms or of exchanges and clearing houses. My guess would be that regulators will be paying more attention to this area in future - not necessarily by setting a whole raft of new rules; more probably by moving it up their priorities in their general supervisory approach.

So supervisors may increasingly, for example, want to talk to exchanges, clearing houses and firms about their IT strategy, the management and development of IT projects, the integrity and security of their IT systems and the arrangements they have in place surrounding outsourcing and external suppliers.

Conclusions

In conclusion, technology is changing markets fairly significantly. This poses big issues for market regulation, both domestically and internationally. At the FSA, like most regulators, we are working on both elements.

As I previously mentioned, we issued a discussion paper at the start of the year that covered many of these issues. We have had interesting responses. They have been broadly supportive of the need to evolve our approach to markets. But they have also warned us to proceed with caution in what is perceived as a complex area, to think internationally and to be mindful of the wholesale/ retail divide. At the moment we are proceeding with caution. And we are giving consideration to whether there may be other (new) risks in the emerging marketplace that have not been adequately addressed, and to whether, and if so how, we could usefully calibrate regulation according to the different characteristics of markets in different asset classes. We expect to have reached some initial conclusions, and to be in a position to say more, later in the year.

I’d like to end by emphasising that the FSA published its discussion paper because we thought it would be useful to generate a public debate on what the impact of technology, on both market structure and participants roles, might mean for regulation. That debate is giving us the material to decide whether changes to our current regulatory framework might be necessary, and I hope we can continue it here today.

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