Thomas Krantz is Secretary General of the World Federation of Exchanges (WFE), a trade organization representing the vast majority of global exchange-traded business. He has been with the federation since 1997. He recently spoke with JLN editor Sarah Rudolph about the mission of the WFE and the challenges of the current regulatory landscape.
Q: Tell me a little about the World Federation of Exchanges. What is its mission? You mentioned you do “advocacy, not lobbying.” What is the difference?
A: We have been doing advocacy for many years. By that I mean trying to influence broad policy debates without getting involved in specific national legislation, which is an area beyond the reach of an association of our scale. With 52 members scattered across the globe, that would simply be impossible. We work a lot with global policy makers, primarily those involved in capital markets development. OECD is one; the current questions there revolve around corporate governance of listed companies and competition between different kinds of actors in the exchange space. But it’s really more IOSCO and the International Federation of Accountants (“IFAC”) on audit practice or IASB on accounting principles.
You lobby if you’re involved in Article 13 Rule 9 in such-and-such a legal text. We don’t get to that degree of involvement in national legislation.
Q: The WFE works with all those organizations you mentioned?
A: Our colleague at the Johannesburg Stock Exchange actually chairs the external global advisory group for the audit standards body of IFAC. WFE is an active member of IOSCO. These are major involvements for the secretariat. The point is that none of them legislates in any one jurisdiction. There is a difference between what’s going on at the supranational level in establishing a broad global framework for the financial system and who actually has sovereign authority to legislate and create rules for day-to-day operations. When the Dodd-Frank bill was written in Washington, I doubt that the U.S. Congressional staffers knew enough about IOSCO Principles of Capital Markets Regulation to use those ideas as a framework. Representatives are very domestically focused, which is a shame. Our big problem is getting global coordination of capital markets rules and regulations so that the markets integrate better. It’s very difficult; at a time of economic global crisis in a lot of countries, governments tend to pull inward. That’s not the direction we were going in three or four years ago.
On behalf of WFE, I went to Brussels about a year ago to speak with the EU Commission capital markets persons about short-sale rules. There are global principles written by IOSCO that we quite like; we reviewed them with capital markets regulators as they were established, and they seemed generally workable. For example, you have to be able to sell short if you’re making a market. Also, as operators of the marketplace, exchanges cannot have a directional bias for prices, up or down. As far as we could see from the results, the European Commission ignored IOSCO’s work and decided to go its own route in ways we found rather impractical and inefficient for the markets. In many respects, Dodd-Frank’s broad direction is not necessarily in accordance with IOSCO’s international standards, either.
There is another area important to the capital markets where the U.S. has been slow to get in line with international norms, and that is in accounting principles. The process of harmonization between U.S. and global (IFRS) standards has been going on for years, making the evaluation of public company financial statements across borders that much harder. Too often business and political leaders have had the reflex to think that U.S. accounting standards were the best in the world, until we got an Enron or a WorldCom or a Citibank blowup. Nobody gets it all right — there are surely problems all over the world with accounting – so WFE has been at work trying to assure global coordination of all kinds of market practices and standards, including those for accounting and audit.
Q: What was the WFE’s reaction to the Flash Crash? What are they working on to help prevent another such incident? A: Well, given capital markets structures in many jurisdictions, it is a lot like living in California on the San Andreas Fault. We’ve been stating our concerns for years that market structures were too complex and unfairly built, with different rules and regulations for different actors. For example, an ATS [Alternative Trading System] in the U.S. doesn’t have the same responsibilities for maintaining broad, high quality market infrastructure as a registered exchange. The exchange business is about far more than just trade execution; it is a complex, interconnected package of services that guarantees fair access to price discovery. The idea that others should compete in the execution space only has led to pricing pools here and there. Internalization, “upstairs trading” and off-exchange dark pools draw order flow away from the public view.
WFE has stated for years that it welcomes fair competition, with actors in the exchange space having the same responsibilities to the markets. What we have in this case, in the U.S., is an unfair and potentially unstable environment. As individuals, you and I most likely do not have access to dark pools, private placements or certain types of IPOs. I’d say that’s not fair. We might think our broker would execute an order for our own savings on one of the public exchanges, which are certainly liquid enough for retail orders such as yours and mine, but it isn’t necessarily so. We don’t know where those orders are going anymore – though it would come back with some indication, probably in the form of boilerplate in tiny print.
We’ve been expressing our anxiety to officials that the U.S. and European models are not robust for raising capital and offsetting risk, which is what exchanges do. That is their economic function, and no other actor replaces those two roles. I also wonder, if it took the U.S. authorities charged with the flash crash investigation four months to figure out what the likely “trigger event” was, then who is watching over what is happening in the markets on a day-to-day basis? Exchanges can only see what goes through their systems, but the majority of the market is not on the exchanges these days. What’s the economic and social purpose of this type of trading?
A: The argument made by those operating alternative platforms is that, yes, they have reduced costs, and when I listen to French radio in the evening I hear “Come trade on my electronic bourse for six euros!!!” But that is the explicit trading cost only. It costs to watch prices in multiple trading pools. There is a fairness cost, and what about the implicit cost of all those orders not being shown to the central, public marketplace? And what about the cost of trading in a market without complete surveillance? All of that is now escaping the view of any one agency.
And markets have gotten thinner; the “touch point liquidity” has dropped considerably from what is displayed in the public order books. Trading is all over the place. So when alternative execution venues promise lower costs, they refer to the trade execution only and are being quiet on the other implicit costs, which we cannot quantify. No one can – because rerunning the computers to see what it might have been is pure hypothesis.
Q: What fixes is the WFE working on for this problem?
A: It is an ongoing multi-year conversation. IOSCO is very worried by fragmentation of the central marketplace and is searching for responses; it’s a global organization made up of the world’s SECs and CFTCs, and they must find compromises that sovereign governments will grant them. They can’t impose their principals on sovereign governments.
Q: Is it a problem that the SEC and the CFTC are both underfunded?
A: That’s a huge problem for the world’s capital market authorities, which are generally underfunded everywhere. The members of WFE advertise themselves as “regulated” exchanges – where government matters. This is distinctive to our commercial identity. If the government cannot follow the market with us, then it matters. That’s the problem with the alternative trading platforms. They are participating in our space but without the same obligations to support the common good, and their prices are not accessible to all.
Q: You said OTC contracts should be standardized, cleared, and reported to a depository. Can you elaborate on that?
A: Exchange-listed and traded securities are within the regulatory environment; OTC contracts and trading are generally not, or are far less so. As the crisis events from 2007 onwards demonstrated, the origin of our difficulties was in very poor information on OTC. We don’t have good clear trading data in complex environments with multiple actors, even for securities that are listed and still traded on exchanges. In Brazil and Hong Kong, I believe, all financial contracts are reported to the commission. They see both OTC and on-exchange data. We don’t have that information in Europe or the U.S., so we remain largely unable to judge the overall exposures of our clients, both their on- and off-exchange participation. As G20 has stated, we need to get a better handle on OTC, which has its economic function to perform. The authorities need to know more about what is going on here – the current example being swaps on sovereign Greek debt where exposures are unknown. Standardized contracts can be cleared, which would greatly reduce overall capital markets risk. Related to this problem of OTC is the question of how does any agency, U.S. or otherwise, make sense of the tremendous amount of trade data flowing through computer systems. In the U.S. and in many other jurisdictions, there is no central reporting and no evaluation of OTC and swaps positions. With such incomplete knowledge, no one can even make a start at evaluating the state of the marketplace.
Q: You mentioned that the U.S. Congress is looking into why fresh investment capital is not being formed in the U.S. markets and sent a letter to SEC Chairman Schapiro asking why there are so many fewer issuers of securities in the U.S. than we had years ago. Can you talk about the problem with capital formation?
A: Congress is looking into that, and WFE is all too aware of this fall-off in our basic business and economic purpose. Ten years back, the market capitalization of equities on WFE exchanges was on average over 90 percent of those jurisdictions gross domestic products – today, the figure has moved below 70 percent. That is a very heavy statistic to move, so the fall is dramatic. We have been discussing this with our colleagues at the OECD. Ideally we as citizens should be able to save money, invest in these companies looking to raise capital for their development, and slowly earn more money over the rest of our lives — but that fundamental aspect of the markets is breaking down.
Q: What is the danger of regulatory arbitrage because of new regulations being implemented country by country? A: Say a U.S. saver has an interest in a consumer goods company, Unilever in Amsterdam or Proctor & Gamble listed in New York. Or Exxon vs Royal Dutch Petroleum. Can you be treated fairly in each marketplace when the rules keep changing? Can you easily find out what the investment and trade execution rules are in these markets? These are not hard examples – as we go further around the world, the complexity rises dramatically. Yet there are opportunities out there for savings that individuals should be able to get at. It’s hard for anyone other than the big professionals to get precise market operating information. We find that unfair. WFE has stated its support for globally consistent capital market rules and regulations to ease cross-border business flows.
Q: The WFE just released a report on derivatives trading. I was looking at the section on stock options. The greatest growth by far in 2010 was at the Korea Exchange, followed by Tel Aviv, India, and MexDer. But many of the U.S. and European exchanges seem to have been waning in volume. Why?
A: Year on year, 2009 to 2010 was not a great year for the U.S. options business, but business picked up in 2010. Overall, in the last 10 years volume has been growing smartly in U.S. options as well. I think that was the first down year-on-year in about a decade.
The Korea Exchange options contract is huge, because equity options are very easy to use and the Korea contract is on the Kospi index, the most widely traded derivatives contract globally. It is priced very well – to be very easy to use by individuals. It’s not expensive, the terms are simple, and clearly a large part of the Korean public “gets” it. You don’t have a phenomenon like that if the contract is complicated.