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21 February 2012

Don’t Confuse Market Structure with Regulation

As with so many things in today's global financial markets, the devil is in the detail, or perhaps the definition, says Hegarty.

As with so many things in our global financial markets today, the devil is in the detail, or perhaps the definition.

The growing complexity and volatility of today’s financial services industry does not come free of twists and turns. Yet despite the changing times and unpredictability of the markets, we must avoid falling into the trap of distancing ourselves too much from the original meanings and nuances of particular concepts or notions that make our industry what it is today.

Using terminology loosely may lead to unintended misconceptions or misunderstandings, and in turn, to mismatched conclusions.  It seems, for example, that the industry has started to use the terms “regulation” and “market structure” interchangeably when clearly regulation is but one element that makes up market structure.

Market structure is a concept that has increasingly been subject to such potential confusion. And this may not be surprising because, as a term, ‘market structure’ is used, industry-wide, and the boundaries of its meaning are blurred. Its connotations seem ever changing. Just three years ago, a differentiation between trade and post trade market structure would not have been viewed as such. Today it’s the norm, even the requirement.

Traditionally, market structure – in any industry – describes the state of a market with respect to its competition. As a concept, it touches upon and is influenced by a wide range of market characteristics. In global financial markets major factors that continue to shape the market include: technology advances and innovation, marketplace and post-trade fragmentation, cost containment, fluctuating trading volumes and volatility, the need to deliver and enhance transparency industry-wide, and shifting global economic influences and regulation.

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.

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13 Comments to "Don’t Confuse Market Structure with Regulation":
  • Missing

    21 February 2012

    i think the speed of change is increasing.


    UBS Turning Whistleblower in Libor Probe

    look at the impact on derivatives.  how do you stop manipulating the interest rate if the market has been built around cheating?

    and if whistleblowing pays off for an institution, then other financial services firms might be encouraged to do it.

  • Missing
    John H Eley

    21 February 2012


    While I agree with the stated premise of the article - it is important to remember that market structure and regulation are not synonymous, I disagree with Rob’s definition of market structure…”market structure – in any industry – describes the state of a market with respect to its competition.”

    In the financial markets, market structure is simply a description of how buyers and seller exchange ownership of a given security.  Price and liquidity discovery, specific exchange mechanisms, payment, clearing and registration are all details.  In general, markets evolve continuously to reflect the needs of the participants and their relative power.  The primary components that accelerate or slow these evolutions are regulation, technology and the power of the strongest incumbents.  Another way to state Rob’s theses would be; “Remember, regulation is just one of several variables that impact market structure.”

  • Missing

    21 February 2012


    I don't want to split hairs and maybe this comment is irrelevent to your main point.  But I think in some sense you are both correct.  Market structure does usually describe the competitive landscape -- is it a duopoly, a monopoly, are there many competitors -- in an industry in standard industrial organization economics.  Market microstructure is a term that developed in financial markets in recent years to describe the detailed analysis of how people trade securities and how the rules and institutional structures matter -- is it an auction process, a deaer market, who supplies liquidity and why, what happens if you change the priority rules, the tick size, etc. ?


  • Missing

    21 February 2012

    Rob, good discussion.  For public  companies, we define market structure simply as "the behavior of money behind price and volume" so that it encompasses a broad swath of behavioral determinants. 

    I would argue, however, Rob, that US markets have been increasingly defined by rules rather than commercial interaction since Congress in 1975 deemed the securities markets a "national asset" (bizarre in a country where private property and inalienable rights are sacrosanct) and set in motion decades of regulatory changes culminating in Reg NMS. 

    Proceeding to it from the order handling rules, decimalization and the Global Settlement, human interaction has been redefined by rules into something humans would never naturally choose. 

    The result is the most contrived, manipulated, and managed market in the US.  The consequence is what always arises from contrived and manipulated markets: Some few prosper mightily while the whole construct slowly strangles itself to death.

  • Comment_ceo

    21 February 2012

    To me market structure is a combination of five fundamental elements, namely, technology, regulation, information, participants and instruments. Of these five elements the one that appears to change the most is regulation (perhaps because it seems easier to affect) which may help explain why Rob posits that regulation is being treated as a synonym for market structure. 

    Participants (which include regulators) motivate market structure change from time to time (e.g. the introduction of HFT, dark pools, short sale bans, circuit breakers etc). Regulators are required to sign off on these changes under their universal mandate of ensuring that markets are fair and efficient.

    The big problem, in my opinion, is not that some now confuse regulation with market structure (although I understand Rob's sentiment...don't gte carried away with the need for regulatory chnage only), but rather that regulators have not developed an objective (evidenced based) framework within which to evaluate all market structure changes. 

    In other words they have not defined and sought operational measures of fairness and efficiency (collectively referred to as market quality) with which to measure the impact of market structure changes on market quality. This may help explain Tim's view that markets are a combination of elements that are not working. 

    As a result market structure change is motivated largely by authority rather than evidence. The decision to impose short sale bans and circuit breakers in the wake of the flash crash are good examples of the lack of a coherent framework. There is no evidence in support of these market structure changes on market quality.

    For those interested in reading the beginnings of a market quality framework see Evidence-Based Policy Making for Financial Markets: A Fairness and Efficiency Framework for Assessing Market Quality published in the Journal of Trading, Summer 2011, Vol. 6, No. 3: pp. 22–31.


  • Comment_salarnuk

    21 February 2012


  • Missing

    21 February 2012

    Sal, that's brevity and precision at its best. 

    Mai, I'd say only that any mandate to make markets fair and efficient, like any to "improve competition," means regulators have crossed the line from laying ground rules to determining outcomes. And the market is then no longer free. 

    We may as well have referees in football place the ball where they think it's best to ensure fair outcomes rather than where the player was down.

  • Missing

    21 February 2012

    Interesting thoughts, Rob. To me they're sort of Yin and Yang. Regulators work with their concept of "fair," "desirable," and "equitable" and you get rules which result in structure. Because the resultant structure either fails to conform to the concept, or over time, the concepts change (or technology or other environmental factors evolve) you get more and different attempts to regulate and the cycle persists. I think the danger is not in confusing the two, but rather when the underlying concepts of fair, desirable, etc, become distorted through the influence of special interests.

  • Comment_hegartyrob2

    22 February 2012

    Hi all - Thanks for the comments...looks like the debate has struck a chord!

    Let me try to address them all.  First, I don't think I said the speed of change is decreasing.  In fact, I think it is increasing.  However, I did say "Regulatory debates are bound to take a back seat, leading to a visible slowdown in rule implementation."  So, the pace of change isn't slowing down, but the pace of rule implenentation surely is as we approach election day (note the CFTC's difficulty in marshaling a three-vote majority for core Dodd-Frank rulemakings, as done in yesterday's decision to pull the entities definition rule from tomorrow’s public meeting).

    Secondly, the definition of market structure is pretty clear when it comes to defining it broadly within business (as noted by Jim Shapiro). The definition has been expanded (or narrowed depending on your view) when it is used in the financial markets, and correctly described by many of the comments above.  The point of the commentary (which apparently I didn't make very clearly!), is that regulation is but one element of market structure wihtin the global capital markets and not the only defining characteristic or driver of market structure change.  I think Mai re-stated this very well...thank you!  I will say, I don't agree with some people (none here) that use "market structure" to describe the trading behavior over time of a partcular security, as is often done in the retail (and mostly penny stock) market.

    Sal: Please elaborate....I have no idea what you mean and would like to understand your thoughts.

    And I like the football referee analogy...but I'm partial to sports analogies!

    In the end, we clearly have a market structure which is less than optimal, to say the least.  And regulation -- for good or bad -- will determine whether we fix it or make it worse over the coming years.  Let's hope for the former.


  • Comment_230146_210851315613283_100000652474653_678322_2285980_n

    24 February 2012

    i think on regulation ;its about time time that we all admit that our exchanges ; especially eurex ; can no longer be self regulatory . They have been guilty for years in ignoring trading abuse for the sake of profit and I believe it is them ; the exchanges ; who should  be punished .

    we have to adopt and accept regulation and realise that there are alot of folks out there who will do anything to cheat if it means money . our regulators are needed asap

  • Missing

    26 February 2012

    crammond1964, the SEC approves every order type that exists. 

    The SEC approved flash orders from Direct Edge long before the Themis folks raised concerns about them. Then suddenly the SEC was self-righteous. The SEC approves mid-point peg and post-only orders, and the combination thereof, while simulteneously in public expressing concerns about dark-pool transactions. 

    You're making the ordinary human assumption that somehow between the street where the common person walks and the doors through which regulators pass to assume Praetorian authority over the lives of others, that human nature will be suspended and somehow they'll be righteous and good. 

    Read these rule filings for all 13 SROs, every one of which is reviewed by Regulators whom you think we need more of: 

    Read the SEC budget here, noting in particular page 13 and its fine print: 

    The SEC collected 1.2 BILLION DOLLARS in Section 31 fees in 2010 (est $1.3b) in 2011 (see p 13). These come from trades on exchanges and trades between brokers. The more transactions, the more money it makes. And since it's required by law to cover its budget with assessments, no single capital-markets entity has a greater incentive to see HFT persist than the regulatory body you think we need more from. 

    What's more, beginning in 2012 and as a result of Dodd-Frank, all Section 6(b) fees save $50m to the SEC reserve fund, will now flow to the Treasury General Fund. Since these fees for issuing securities are projected to account for $394m of 2011 SEC revenue but zero in 2012, the SEC will be that much more pressed to increase fees and see more statistical arbitrage.

    Corruption throughout human history accrues at the source of power.  That's what you want to keep the source of power the individual. Then corruption is confined to the individual. At the rate we're going, we'll all be oppressed subjects of an empire -- what we fought to escape. 

  • Missing

    26 February 2012


    SEC Reviewing U.S. Trading Practices After Decade-Long Shift to Automation

    yes, timquast, they do approve the rules, based on "public" input.  but usually only people with financial interest in these rules comment.  and their comments are self-serving.
    some people, perhaps like me, are commenting on rules.  the SEC has hired some people who were in the financial industry to review practices.  and the closer we get to implementation of rules, the louder the yowyow from the financial industry gets.   last fall, the SEC went to EDGX and found systematic violation of market regulations.  this year, broker audits.  also this year, stock market volume falls markedly while stock market prices increase and the investor public appears to be watching but not buying or selling.  the stock market could be falling on its nose collectively, even without implementing regulations.  if so, that would mean a huge correction of some type.
    many people in financial institutions assume the past predicts the future.  this is not the case.  there is a trend, but trends can change unexpectedly.
    you say the SEC is getting paid off?  maybe they used to be.  however, now governments realize that it is in the interest of national/global security to respond to the threats in the financial system.  in the past, they may have fiddled while rome burned, but i think it would be an error to rely on the SEC/FBI/DOJ to rubber stamp this robbery.  i think the global regulatory bodies now realize that the world financial system is broken. 
    counterfeit securities, accounting subaccounts, failure to deliver (meaning naked shortselling), not reporting transactions - all are symptoms of problems in the market.  gaming in the financial system has been the rule and the financial system has adopted, institutionalized fraud.  check out the FINRA disciplinary actions, the SEC actions.

    FBI Pulls Off ‘Perfect Hedge’ to Nab New Insider Trading Class

    i predict it will be governments+banks vs. brokers+traders.  brokers are broke and traders will either melt away or declare bankruptcy here and try to live on their overseas stash.  i think the brokers and traders made a huge mistake, thinking everyone else would just hand over their wallets.

  • Missing

    26 February 2012

    Shamlet76, we comment too. I hope it's meant something: 

    The problem is the "financial system." 

    Is there a grocery story system? A footwear system? A restaurant system? Movie theater system? Dental system? When you find a commercial activity modified by the word "system," you have encountered massive over-regulation and interference with market mechanisms. You should immediately stop, drop, roll away, locate some matches and set the whole thing afire, and start over before it's the destruction of your culture.

    As to insider trading, we're discussing midpoint peg orders.  HFT.  Charging someone with fraud for "insider trading" is akin to ticketing a passenger on a commuter train for speeding. It's absurd. When one knows how markets function today, one realizes that prosecuting people for insider trading is mob-style extortion, an effort to distract attention from the wreck regulators have made of our once-vibrant capital markets.

    Any chance I get, I advise people to read the Federal Register for a few days. This is the compendium of rule-propagation in the land of the free: 

    Need I say more? This is what our markets look like.  No wonder we're drowning in our own saliva.

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