The way in which market structure, as a term, has been perceived through the years has varied widely and considering its definition is subject to market events, changes of focus in the industry and economic downturns, this should come as no surprise.
To a large extent, the 2008 financial crisis transformed the way in which market structure was viewed and addressed by the industry. The financial crisis set the stage for what was going to become, and still is today, the platform for a regulatory overhaul as has not been seen in financial services before.
Post the days of the Lehman collapse, discussions around regulation inevitably gained ground and the need for greater market oversight took the industry by storm. In doing so, regulation also seemed to take over the vision of market structure itself, its connotations and even its definition. This is true to the extent that in today’s markets, and in the eyes of many, market structure has lost its traditional connotations and become a synonym for one of the most imperative and vital ongoing developments and discussions in the industry: regulation.
Far from being a synonym of market structure, as some market participants seem to be addressing it at the moment, regulation remains one of the most important drivers shaping market structure at the moment. The shift has been major. Prior to the days of September 2008, few would have mentioned regulation – let alone legislation – as a main driver behind market structure change. At the time, other factors such as cost reduction, risk mitigation and technology innovation would have been mentioned instead. Today – only four years later – we find ourselves exploring how regulation appears to have taken over how market structure is considered by the industry as a whole.
Regulation, Uncertainty & Change
Such a wide disparity is understandable. Regulation has become the biggest influencing factor in changes to market structure by a wide margin and looking at the current regulatory environment, and what is yet to come, there is no doubt as to why this is.
Both Dodd-Frank in the U.S. and the European Market Infrastructure Regulation (EMIR) in Europe promise to raise the regulatory bar in ways we haven’t seen before. By demanding exchange trading and central clearing for OTC derivatives, new regulation of hedge funds, new definitions of accredited investors, and reporting on compensation by large companies, Dodd-Frank promises to have a vast impact on financial services in the U.S. and beyond (note the increasing heat being brought upon by “extraterritoriality”). And with EMIR, the requirement for clearing and reporting of OTC derivatives, as well as setting out operational requirements for central counterparties (CCPs) also promises to drastically alter the European regulatory community.
Last October, the European Commission’s release of the Markets in Financial Instruments Directive II (MiFID II) proposals further highlighted the challenge industry faces, as well as the changing times and the push for transparency. When MiFID came into force, in November 2007, the regulatory arena was very different. The revised directive evolved from a set of rules to protect retail investors to a set of proposals to increase transparency at fragmented European trading venues.
MiFID II is also digging deep to examine what high-frequency trading (HFT) is all about in Europe, while the Commodity Futures Trading Commission attempts to define and dig deep on HFT in the U.S. In a push to enhance further transparency, in an idea first articulated by the U.S. Securities and Exchange Commission post the flash crash, automated traders will be required under Mifid II to post bids and offers – to make markets – throughout the day regardless of market conditions. At the time, the International Organization of Securities Commissions (IOSCO) identified the use of HFT as a contributing factor to the crash. And with CFTC set to create a subcommittee devoted to HFT and its effects on the market the regulatory focus on this space is only bound to grow further.
Despite the ongoing regulatory discussions, however, we must not forget the level of uncertainty that lies behind such talks and how uncertainty may affect future market structure. The politicization of regulatory debates has become, as was expected, inevitable as the race for the White House intensifies. What was once a foreseeable shift from legislation to campaigning in the U.S. is already becoming a reality. As election campaigns heat up, distraction from the implementation of outstanding rules will rule the day for the remainder of this year, anyway.
Regulatory debates are bound to take a back seat, leading to a visible slowdown in rule implementation; however this temporary period will not represent a halt to the regulatory push. The end of the race for the White House, come January 2013, will have a direct impact on the legislation that is finally passed.
Such uncertainty is also bound to translate itself in Europe where economic conditions are poised to accelerate regulation and accentuate market structure fragmentation. While the U.S. braces itself for the presidential election, Europe finds itself having to tackle a crisis that has not only gripped its financial institutions but also its governments. And this may only have a negative impact in years to come as trading firms and investors look to identify stronger countries and position their portfolios and operations accordingly. The European financial crisis is perhaps one of the best examples of regulation not being a primary driver of market structure change.
In the years following the 2008 financial crisis, the industry has seen a new era of regulatory reform unravel, bringing regulation to the fore as the primary driver of market structure change. The vision around the type of supervision necessary in today’s markets has changed, complexity has grown and firms are already experiencing and getting ready for regulatory change and what is yet to come. However, it is critical that we not forget the other significant drivers of market structure change beyond regulation.
Technological innovation, fragmentation of markets and fluctuating volumes are but a few of the drivers of market structure that should not be lost in this relatively recent wave of regulatory change. So let’s not confuse market structure with regulation. They each deserve their own place in the future of global financial markets.