Investment Services Directive - Creating a Single European Market
By Richard Britton
The speaker is an independent consultant on financial regulatory issues, participating in the event on behalf of the International Securities Market Association (ISMA), Zurich
Speech to EU Strategy and Directives For Investment Business, Westminster and City Conference, Claridge's
Tuesday, October 1, 2002, London
The brochure for this conference set Tim and I the following question: 'Can we create a single capital market fit for the 21st century in which proportionate and properly targeted regulation sustains investor and issuer confidence whilst accommodating diversity of needs, rewarding innovation, and recognizing the power of competition to achieve economic and political goals?'
In my view the answer is clearly 'Yes'. But if you ask me will we do so then, while I remain, as always, an optimist, the answer is not beyond doubt.
In developing its proposal for modifying the current Investment Services Directive the Commission is to be congratulated for the extensive consultation it has undertaken, and the thoroughness and openness with which that process has been carried out. From its original Communication to the European Parliament and Council nearly two years ago through two public consultation papers and two open hearings, the Commission has listened carefully to what issuers and investors, investment firms and exchanges have had to say. No one can claim that their views have not been sought and considered - even if, as in any process of consultation, the end result does not satisfy everyone.
Not that publication of the proposed directive in a few weeks time will mark the end of the process. Far from it. That is because this two-year period of consultation has provoked a hard and furious debate. Its conclusion - who wins, who loses, will there be a clear, definitive outcome or, as with the current ISD, a series of messy, last minute political compromises - will determine the structure of Europe's capital markets for years to come and will be a major influence on whether those markets will fulfill their undoubted potential to become the key driver of European and indeed global prosperity.
At its highest level, the debate is about whether the securities market can be based on fundamental concepts of fairness and equality for all users at all times, and whether it can be structured to be almost self-policing in its operation. Or whether, in order to meet the high-level objectives of public policy, the market has to be an untidier place, where the same users will sometimes be winners and sometimes losers, depending on what they want to achieve and how their securities investments are organized. In this case its rougher edges will have to be worn down by pro-active regulators in order to properly protect those investors who need protecting and to ensure the integrity of the price formation process.
Of course it has not been possible to confine the debate to these Olympian heights. Some take the more cynical view that the primary driver is not high principle but the money at stake in the competition for order flow. The transformation of exchanges from mutual organizations or public utilities into shareholder-owned, 'for profit' organizations and the transformation by merger of some exchanges into pan-European monoliths, has intensified the argument As has the possibility of ATSs replicating the success they have had in the United States, here in Europe. But perhaps an even more important factor has been the growing dichotomy between the commercial interests of exchanges and those of their largest members and their clients.
Nevertheless, both sides claim the moral high-ground. I am by no means a neutral observer of this debate, both from my background and in my current role as a consultant. As a bond salesmen in the 1970s and 80s I played a small part in what is one of the greatest success stories in the evolution of the global capital market. And it happened here, in Europe, in practice in London. In less than forty years, the Eurobond market has gone from zero to become the second largest bond market in the world and the largest for corporate bonds. Last year, for example, there were over 17,600 bond and medium term notes issues for a total of over EUR 2.3 trillion. And that happened despite the market having almost none of the characteristics which it is claimed by some are essential for a market which is fair and efficient for all. It developed and remains almost entirely outside established exchanges, in the fragmented over-the-counter market. It is based on internalization of customer order flow by banks and brokers and their acting as principal dealers, agents and advisers to issuers and investors - multiple conflicts of interest which have to be managed. Compared to equity markets, its transparency has been limited. And yet the number of defaulting issues has, at least until recently, been very small. Investors have received good returns over many years and their confidence in the market has been steadfastly maintained. It has to be said that the Bahnhofstrasse in Zurich is not full of widows and orphans who have been deprived of their last centime by unscrupulous bond salesmen. But back to the equity markets - since that is where the debate is focused and where, so I understand, the Commission has chosen to concentrate its most controversial proposals.
I pitch my tent on the moral high ground of investor choice - the right for investors to choose the execution services they want. The current ISD enables investors, both retail and institutional, to choose between a wide choice of order-execution methods, offered by both stock exchanges and investment firms. It does however permit Member States to limit investors' choice by, requiring domestic retail investors to deal through an exchange - the so called 'concentration rule'. Some Member States have taken advantage of that provision. Throughout its consultation the Commission has suggested that a modified ISD should remove these remaining barriers to investors' ability to choose freely the order-execution methods they want. This stance is widely - although not universally - supported because it is consistent with the objectives of the single market programme: to create choice, facilitate competition, and improve cost-efficiency.
But there is debate about whether investor choice needs to be supplemented by new Europe-wide controls. It has been suggested that the publication of investors' orders to the market, or 'pre-trade transparency' - a feature of order execution by stock exchanges - should also be imposed when banks and brokers execute client orders 'in-house' either by executing one client's buy order against another client's sell order or by executing against the bank's own position - so called 'internalization' or 'in-house matching'. Mandatory order publication would impose new, Europe-wide constraints on capital markets which would undo many of the beneficial developments of recent years, that have resulted in European capital markets becoming among the most innovative, diverse, and competitive in the world. Its advocates claim that choice would continue to be permitted as it is today, but in reality the choice would be illusory. With mandatory publication, order execution methods would be almost identical, providing a limited range of services at uniform prices - the financial services equivalent of Henry Ford's 'you can have any colour car you like as long as it's black!' In effect it would reimpose the concentration rule but remove Member States' discretion as to whether or not to impose it.
In my view this would be a step back, not forward. Failure to respect the principle of investor choice would deter investors, particularly institutional investors, from using European markets and deter innovation by banks, brokers, and exchanges competing for investor orders. This would reduce liquidity, drive up the cost of equity trading in Europe, and make European markets internationally uncompetitive. Business would go to other parts of the world which do respect investor choice and provide competitive services.
My understanding is that the Commission has remained consistent with its view that the concentration rule should go, and should not be re-introduced via the back door of a new, uniform, transparency regime. But if so, it is likely to meet strong opposition from some Member States in the months ahead. I have no doubt that there will be other mechanisms proposed - always, of course, in the name of fairness or investor protection - which will, directly or indirectly, achieve the same result.
Those arguing for the denial of investor choice make several claims. First, they claim that it would be good for investors to have all their orders published to the market. Of course investors have a commercial incentive to attract the widest possible trading interest in their orders. But they may also wish to obtain faster execution than exposing their orders to the marketplace generally permits.
They may want improvement over the exchange price, a lower commission, or to eliminate the risk of the market price moving against them. The balance between these factors in a particular case determines an investor's preferred execution method. Banks and brokers can often satisfy these needs more effectively than exchanges. Take, for example, the case of an investor who wants to invest in a small company whose shares are closely held. He, or his broker, will go to a broker who follows the company closely. He in turn will approach shareholders that he believes might be potential sellers and negotiates a price. This will usually result in a better price than if the order was merely displayed on an exchange's limit order book in the hope that one of those shareholders might, by chance, see it and act on it.
It is also claimed that investors get a worse deal if their orders are not sent to an exchange or otherwise published to the wider market.
But again, in practice, this argument is wrong. There are strong competitive incentives for banks and brokers to provide good prices for customers - bad execution is bad business. These incentives are reinforced by 'best execution' rules which ensure that retail investors whose orders are executed off-exchange get prices at least as good as exchange prices. Publication of completed trades enables investors and brokers to check the quality of execution. In the UK, this combination of incentives and rules works well. The best execution rule requires that investors obtain a price which is at least as good as the price on the exchange. Competition ensures that 'Retail Service Providers', specialized market makers who execute most retail customers' orders, in fact improve on that price in around 80% of cases.
Does it require competent and pro-active regulators? Yes it does. Does the rule require amending and updating from time to time to ensure that it deals effectively with the challenges posed by changing market structures, such as the creation of competing exchanges and ATSs? Yes it does. Must investors be provided with sufficient information so that, with some due diligence on their part, they can shop around for the means of executing their trades that best meets their needs. Certainly.
It is alleged that all this is more difficult and expensive when carried out by anyone other than an exchange. I disagree. Good regulation is not cheap but neither is the cost of verification excessive. Today, thanks to IT developments, investment firms which automate the process of order routing and execution not only provide clients with finely differentiated pricing, but also generate accurate, highly time specific audit trails which promote cost-efficient compliance monitoring. I think that experience in the UK clearly demonstrates that the benefits of good quality regulation outweigh the costs of denying investors choice by, in effect, entrenching existing monopolies.
So if it's not possible to prove that individual investors get a better deal from a consolidated market place and also not possible to prove that a fragmented market gives them a worse deal, what's left.
Quite a lot as it happens, although the argument shifts from individual benefits to collective benefits. The focus of the argument shifts to market efficiency. It is argued that the interests of an individual investor trying to execute a trade in the way that best meets his needs should take second place to the needs of the market as a whole.
In order to maximize market efficiencies generally, it is argued that as many orders as possible should be published to the market, so that at any point in time the 'best bid' orders from buyers can match the 'best offer' orders from sellers.
This is grossly simplistic. Capital markets are dynamic and competitive places. Any risk that spreads might widen and liquidity be lost from the exchange because of 'internalization' would be more than outweighed by increases in liquidity and reductions in transaction costs and clearing and settlement costs - benefits which arise only in diverse and competitive markets. Furthermore, the increased order flow, and banks' and brokers' active involvement in both exchange trading and 'internalization', would counteract any potential widening of 'spreads' between 'best bid' and 'best offer' orders. Investors are constantly making and amending decisions about the price and conditions on which they wish to deal based on their own objectives - for immediacy, for the best current price, to achieve a price better than the current price, to preserve the value of their remaining investments. Since it takes two to make a trade, the price each investor puts on an order, and the investor's willingness to trade, also takes account of their perceptions of the intentions of others.
Even if a particular 'internalized' order could, if sent to the order book, have temporarily helped to narrow the spread for a particular security, the 'internalization' will not result in a general widening of spreads. Any such widening would affect the perception of other investors, encouraging them to submit additional orders for execution at better prices, which would counteract the widening. Furthermore, banks' and brokers' links to both exchanges and other execution venues, together with rapid publication of completed trades, means that any tendency towards widening of on-exchange 'spreads' as a result of 'internalized' trading would be rapidly eliminated by traders who are active both on- and off-exchange.
Actually, the debate on pre-trade transparency is very odd. No-one is suggesting, as far as I know, that an investor should be obliged, by law, to disclose his total trading intentions to his broker. And yet if he does, the proponents of so-called 'full' pre-trade transparency argue that the broker should be obliged, by regulation, to expose that whole order to the market at large. I fail to see why the transfer of information from investor to broker should trigger such disclosure. The result of such a regulation is obvious - investors will no longer be frank with their brokers and liquidity and market efficiency will diminish.
Stock exchanges already recognize the need for different trading mechanisms and provide so-called 'iceberg' facilities, by which investors with large orders can choose to hide the full extent of their orders while still using the exchange's limit order book. Most exchanges also permit, as on-exchange trading, 'crossing' facilities, under which privately negotiated transactions are merely disclosed to the market after they have taken place. The result of these facilities is that 'full transparency', even on-exchange, is a myth.
Now I do not object to that. It seems to me a sensible response to meeting investors' diverse needs while ensuring that they continue to use your system and not a rival's. But I do object to what it leaves un-stated - namely that its OK for some orders to remain hidden - as long as it's an exchange that's hiding the true market situation from investors and not individual banks or brokers.
I repeat, regulation cannot make an investor submit an order if he believes that the execution method or the rules under which it operates will damage his interests. That is why 'internalization' arises: one market model, and one set of mandatory order publication requirements, cannot cater for the needs of all investors. That is also why competing exchanges on their own cannot provide the level and range of competition which investors need. If regulation required the publication of all orders, investors might well hold back orders that they did not want to be published. This would reduce liquidity in the market as a whole, and be more likely to widen spreads. And so the argument shifts again. Even if, it is said, order exposure is not practical for institutional orders, wouldn't it be practical, and benefit the price formation process, to require at least all retail orders to be published to the market?
Here we get to the nub of it. Retail orders often form a majority of the number of trades on many exchanges. But they represent only a small proportion of total activity in the market by value - typically well below 20% - and in today's trading environment often far below that level.
But crucially, prices are formed where the bulk of the market's liquidity is located: not in retail markets, but in institutional markets. Retail orders thus have only a limited influence on the price formation process.
In any case, most of the so-called 'institutional' market in fact represents the collective savings of individual retail investors. Greater liquidity in the market as a whole , generated by competition and choice, means that the whole market benefits from the price improvements and cost savings which investment firms are able to achieve for their clients when those clients, whether 'institutional' or retail, choose to execute their orders off-exchange. The ability of exchanges to display the best price is not harmed by investors' ability to choose between different execution methods. Far from it - the dynamism of the whole market ensures that it is actually improved. If all 'retail' orders had to be published to the market, individual retail investors would be isolated in a rigidly regulated and high-cost market without the benefit of linkage to the main pool of liquidity.
The final argument against investor choice brings into play that old mantra 'same business, same rules'. Shouldn't banks and brokers be required to publish the orders they receive to the market, as exchanges currently do?
We last heard this one in the early 1990s when Europe's banks wanted brokers to be subject to the same levels of regulatory capital as was proposed for banks when Europe implemented the Basle Accord. As put forward by the banks this would, of course, have put most brokers out of business. It was an erroneous argument then, just as it is today. A 'one size fits all' approach tends to distort and diminish competition.
In any case investment firms and exchanges offer different execution services. Unlike exchanges, banks and brokers offer principal execution (that is 'internalization'), provide liquidity to the market, and search the market to find the best deal for the investor. This includes removing risk for investors who want to carry out hedging transactions which require simultaneous execution of two or more trades - shares versus convertible bonds, shares versus options, etc. Very few exchanges provide the necessary facilities or the full range of investments to make multiple, simultaneous transactions possible. Many banks and brokers do. These benefits should continue to be available to all investors.
Exchanges, in contrast, offer a comparatively simple, neutral infrastructure to facilitate the publication and trading of orders.
The business of exchanges is to publish order flow to attract more investors to enter orders onto its system. Regulators have not imposed transparency on exchanges. They have merely taken up and codified what exchanges do as a service to investors. They would do it even if the regulations did not exist. Just like exchanges, brokers publish orders by routing them to exchanges if that is in their clients best interests. But it is misguided to argue that, to avoid unfair competition, all broker execution services should be compelled to adopt the exchange model.
After all, competition is about benefiting investors, not market intermediaries. Different investor needs demand different services and lead to the creation of different order execution venues. Different services pose different risks. Regulation should address the specific risks connected with each service. Requiring investment firms to abide by the same rules as exchanges would probably force them to adopt the same business model as exchanges. For example, investment firms might well stop committing capital to take on clients' risks. This would eliminate existing diversity, choice, innovation, and competition from European capital markets, not promote it: a radical change which would achieve very little except harm to European investors and companies raising capital.
So let me, in conclusion, pose a question and exercise my speakers right to answer it. As regards the European capital market infrastructure, what should the Commission, Member States and the European Parliament be striving to achieve as the proposal to modify the ISD works its way through the legislative process? At the high level they should be seeking to provide improved conditions in which European capital markets can continue to serve European investors and European business at the cutting edge of innovation and competition. As always the devil will be in the detail. The key, in my view, is to provide a legislative and regulatory framework which lets investors and market forces decide. Do not distort markets by imposing over-simplified regulatory constraints. All retail investors, whether they choose to invest directly or to have their savings managed professionally, are entitled to expect that their interests will be properly protected. Regulation plays an important role in providing investor protection and safeguarding the integrity of the market. Banks and brokers can maintain best execution requirements through monitoring the reporting of completed trades. Investors can, if they wish, choose a broker who will execute their order through an exchange. But market forces, not regulation, should both determine the services which best satisfy investors' needs, and define the overall structure of the market. Competitive, innovative, diverse markets ensure that investor choice can drive different market intermediaries to provide the particular combination of good execution and minimal cost that each investor wants. Proportionate application of certain regulations - on best execution monitoring and post-trade disclosure - can complement market forces by controlling any tendencies to malpractice. But measures to constrain market structures, either by forcing retail-size trades to be executed in particular venues, or by forcing investors to disclose trading intentions even when it is not in their interest to do so, would not just harm European markets, but have the perverse effect of harming the very retail investors they were intended to protect.
Ladies and gentlemen, thank you for your kind attention.