Description
The purpose of this paper is to evaluate recent financial system reforms in the USA by
placing them in the context of major structural trends currently underway in the markets, due to
technology and globalization of trading.
Journal of Financial Economic Policy
The (revised) future of financial markets
Paul Bennett
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To cite this document:
Paul Bennett, (2011),"The (revised) future of financial markets", J ournal of Financial Economic Policy, Vol. 3
Iss 2 pp. 109 - 122
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J ames R. Barth, Apanard (Penny) Prabha, Greg Yun, (2012),"The eurozone financial crisis: role of
interdependencies between bank and sovereign risk", J ournal of Financial Economic Policy, Vol. 4 Iss 1 pp.
76-97http://dx.doi.org/10.1108/17576381211210203
Sameeksha Desai, J ohan Eklund, Andreas Högberg, (2011),"Pro-market reforms and allocation
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The (revised) future
of ?nancial markets
Paul Bennett
Rutgers University, Newark, New Jersey, USA
Abstract
Purpose – The purpose of this paper is to evaluate recent ?nancial system reforms in the USA by
placing them in the context of major structural trends currently underway in the markets, due to
technology and globalization of trading.
Design/methodology/approach – The paper describes trends underway in markets and
examines how the new rules recently agreed to in the USA and among regulators globally will
bear on them.
Findings – The paper ?nds that the ?nancial system reforms in the USA can be expected to have
modest bene?cial effects in terms of making markets more robust and ef?cient, and that key trends
affecting markets need to be taken into account as regulators implement the new rules and evaluate
the need for future amendments. Our ?ndings imply that regulators should be willing to closely
monitor the reforms and adjust them quickly as needed.
Originality/value – This article adds the perspective of interacting key secular trends in the
structure of the banking and ?nancial system with the latest regulatory initiatives.
Keywords Economic reform, International trade, Banking, Financial institutions,
United States of America
Paper type Research paper
Introduction
The 2007-2009 crisis in US ?nancial markets not only stimulated new legislation and
capital rules for restoring order and con?dence to markets, but it also highlighted
underlying trends in ?nancial markets that will persist and continue to affect economic
and ?nancial policies going forward. Although public discussion has been intense, the
academic literature analyzing the crisis is still developing. Acharya and Richardson
(2009) compiled a volume of papers that suggested needed reforms even before the crisis
had leveled off, and Acharya et al. (2010a, b) compiled descriptions and critique of
the regulations emerging from the Dodd-Frank and other legislation. Angel et al. (2010)
provide a monogram describing some of the key structural changes to equities markets
leading up to and through the crisis. The Securities and Exchange Commission (SEC)
and Commodity Futures Trading Commission (CFTC) (2010) provide their own
description of the “?ash crash” episode that so enervated markets in the post-crash
months, although their analysis does not address the roles of ?nancial regulation in
allowing the systemto become so fragile. Greene et al. (2010) have provided a thoughtful
discussion of the challenges of regulating global organizations using national-level
authority.
This article attempts to distill some of the most important outcomes of the crisis and
subsequent legislation on the dynamic structure of ?nancial markets going forward.
It ?rst identi?es several important, largely technology-driven trends in market
structures, and then it analyzes how the crisis and associated regulation may be
in?uencing such trends, if at all. The trends are:
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
The (revised)
future of
?nancial markets
109
Journal of Financial Economic Policy
Vol. 3 No. 2, 2011
pp. 109-122
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381111133598
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the continuing globalization and cross-border integration of ?nancial markets;
.
the growth of technologies that help integrate large institutions and, in the process,
increase the returns to scale and scope in banking and investment banking;
.
the introduction of technologies that permit very rapid trading strategies,
including automated trading systems designed to give their users ?rst-mover
advantages relative to other traders; and
.
the increasing presence in multiple markets around the world of very large
?nancial institutions – sometimes dubbed “to big to fail” – that often appear at
least as technologically and politically savvy as the many national-level
regulators, lawmakers, and central banks charged with supervising them.
Froma policy perspective, initiatives such as the newBIS minimumcapital requirements
agreement, the Dodd-Frank reform legislation, and new SEC rules designed to prevent
technology-driven market volatility are reactions to these trends yet appear unlikely to
fundamentally alter them, in part because the affected institutions have been successful at
in?uencing the shape of the regulatory change to limit its impact on their own prospects.
This article ?rst discusses these underlying structural trends in more detail. Next it
highlights selected key provisions of the Dodd-Frank, Basel III, and SEC “Flash crash”
rules that interact with the four trends. While many details of how the new rules will be
implemented are still to be determined, it is nonetheless possible to make some
assessments of how they will in?uence market functioning. The article also notes areas
where more reforms may yet need to be considered.
Four structural trends
1. Globalization and cross-border integration of markets
While diversi?cation by US investors is an old story, the expansion of US international
portfolios has continued (Figure 1), especially outside Western Europe and Japan. This
has been both a result of and re?ected by the large amount of public securities
offerings being made available even in markets that previously were closed to outside
investors or less active (Figure 2). As a result, the de?nition of global markets has
expanded for US investors, and the interdependence of market places has become
stronger. A drop in asset prices in one market can affect the ability of banks to continue
to be effective in another. This increases the reactions of markets in one economy to
seemingly unrelated shocks elsewhere.
Figure 1.
Cross US-border equity
holdings 1997-Q2 2007
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1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Q2
2007
US holdings of foreign stocks Foreign holdings of US stocks
Source: Federal reserve flow of funds
$
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2. Technology-driven economies of scale and scope
Powerful computers and communications are certainly not new. But as innovations have
piledupon innovations andadvancedapplications have become ubiquitous, fundamental
changes have occurred in our banking and ?nancial markets. Data processing systems
have been integrated, allowing near real-time feedback and control over ?rm processes
and risk taking. The art of merging existing systems has also advanced. As a result,
managements of large ?nancial institutions have been able to expand the size their
organizations with more con?dence and effectiveness than previously.
This has allowed some companies to operate on a signi?cantly larger scale. One
example is the expansionof USbanks nationwide inthe wake of the relaxationof interstate
banking. The business of integrating disparate subsidiaries and branches became its own
line of business. The success of organizations in this endeavor helped embolden those
trying to integrate global ?nancial organizations, or to integrate traditional banking and
securities lines as depression-era separations were relaxed. Banks have lent internationally
for decades, and securities have been issued across borders since markets began. But the
ability to control global operations in something closer to real time has encouraged some
ambitious organizations to signi?cantly widen their scopes of operation.
Although the largest ?nancial institutions have been operating on a global scale,
regulation of these organizations has remained ?rmly a national-level responsibility.
While much public-sector effort has been expended trying to coordinate key regulations
such as minimumcapital requirements or accounting rules, the results have been mixed.
For example, while the Basel I minimum capital agreement in the wake of the 1980s
global lending ?asco signalized a good ?rst effort, the Basel II standards were extremely
slow in coming and failed to prevent the recent ?nancial crisis. It is unsurprising that in
some countries the capital rules were not uniformly enforced. For example, in the USA,
large ?nancial holding companies that avoided owning depository institutions escaped
with much lower capital requirements until very recently. Conversely, other regulators
have placed standards on their banks that are stricter than those internationally agreed.
Figure 2.
Corporate initial public
equity offerings by
country of issuer
Other
Asia/Pacific
$17B
Rest of Europe and Mid-East
$54B
USA
$42B
China
$36B
Other Americas
$13B
UK
$15B
Russia
$10B
India
$9B
Brazil
$20B
Source: January-September 2007
The (revised)
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3. Technologies allowing extremely rapid trading
A particularly notable effect of technology on trading in ?nancial markets has been to
speed up order and trade information data transmission, as well as to automate many
trading strategies ( Janovic and Menkveld, 2010). In the ?rst instance, many human
traders have been eliminated and replaced by automated systems. Automated systems
can now make routine trading decisions and make them much faster. Such systems
also allow integrated with back-of?ce automation. The goal of this automation can be
largely understood as attempts to slash costs by replacing people with machines. Some
systems take large orders, strategically break them into pieces, and select the most
appropriate trading platforms for them.
Others forms of automation go a step further, integrating these order routing and
execution capabilities with computer-driven identi?cation of trading opportunities and
security selection. Such automation has been most prevalent in USA and European
equities and equity derivatives. The earliest versions of these were cash-futures and other
arbitrage trades, where costs must be low and speed is essential to trader pro?tability.
More trading based on extrapolative or regressive price projections, automated stock
selections, and other methods continue to spread. These have started in the USA and
spread to Europe, but given the global nature of institutions and markets, it is likely that
very fast computerized trading methods will be applied to more instruments in more
markets, going forward. Therefore, we should be watching closely what works and what
does not in automated US equity markets, for these may foreshadow global trading
methods and patterns in multiple types of instruments and in more markets.
As the role of humans in carrying out trading mechanics has shrunk, and as electronic
trading has risen, one consequence that was not initially foreseen was the competition in
trading system speed that resulted. Human traders have long appreciated the need to
make decisions andact very quickly, inorder to submit orders ahead of other traders. As a
result, theyhave continuedto invest infaster andfaster decisionmakingandtransmission
systems, while exchanges and other platforms have invested heavily to keep up. With
natural physical limits on transmission speed beginning to bind, traders have begun to
compete for transaction speed by placing their machines closer and closer to exchanges.
One way to increase the speed of algorithms is to streamline or eliminate some of the
internal checks or safeguards that would normally prevent nonsensical orders being
submitted, with resultant trading glitches or worse. In the process, these systems and
their interaction in electronic markets have created market prices that sometimes move
faster than humans can mentally track. As news becomes incorporated in public price
quotes and trades even before many participants in the market are aware of the news
itself, the demand for speed is multiplied among traders.
Figure 3 shows the dramatic and ongoing trend in the speed with which orders are
submitted and executed, and the fastest trades now occur are completed in a few
milliseconds. When a human being, whether a trader, exchange operators, or regulator,
recognizes that trading engines have gone seriously haywire, it may already be too late
to avoid a signi?cant disruption in a market’s functioning.
A closely related contribution of computerization of trading has been sharply falling
trade execution costs (Figure 4). This includes not only the transactions fees levied by
brokers and exchanges but also and more signi?cantly the market impact of trades, at
least under normal market conditions, since trading algorithms are typically designed
to submit even large orders in smaller, randomized pieces to lessen their impact on
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market prices. The rising speed and falling marginal transactions costs are of a piece
because they both result from competitive use of automated systems to cut costs and
gain trading advantages.
Automatedsystems provide negligible marginal costs per trade but require substantial
development. As competitors are able to catch up or surpass a trading system, resources
must be continually committed to upgrading systems. As noted, certain functions such as
risk management systems are also in competition with transaction speed within
algorithms, and so it is not surprising that the role of coordinating and regulating the
contention these systems generate in public trading has been left to exchanges and other
Figure 3.
Execution speed,
NYSE equities
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Average seconds to execution
Figure 4.
Falling order execution
costs
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Source: Plexus group, Inc. 2001-2007
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trading platforms. These businesses, in turn, are similarly under sharp competitive
competition. Regulators have been at a distinct disadvantage in playing traf?c-cop in this
new world of electronic markets both because of a lack of resources and knowledge, and
have also been reluctant to intervene in the very complex and rapidly evolving electronic
marketplace. Interventions have therefore tended to reacte to problems rather than be
pre-emptive.
Closely related to the speed and very low marginal trading costs has been the
fragmentation of trading among competing platforms. This has been particularly
evident in US equities trading, where traditional NewYork Stock Exchange (NYSE) and
NASDAQ shares of execution and trading reporting volumes plummeted from nearly
90 percent or more of listed market shares to well under half within the space of a decade.
Fragmented systems emphasize competition, which has helped lower costs and raise
speed. But the competitive pressures among competing markets have also taken away
incentives or individual trading venues to maintain resilient mechanisms for protecting
against trading problems that could spill over into the larger market (Angel et al., 2010).
This became particularly evident in the “Flash Crash” of May 2010, when a ?ood of
orders triggered automatic circuit breakers in part of the market, causing the orders to
spill over or be automaticallyredirectedto alternative exchanges or platforms (CFTCand
SEC, September 2010). In the process, many systems became momentarily overloaded,
and the market stopped functioning effectively, spewing nonsensical prices and trades.
Goingforward, it is virtuallycertainthat computers will continue to increase their role
in market trading, and competitors will develop faster and more complex technologies
for trading. So far, these systems have been largely con?ned to the US equities markets.
But they give such an important speed advantage in decision making, in communication
of trading instructions, and in data transmission that they will surely become more
prevalent in equity, ?xed income, and derivatives markets globally. The “?ash-crash”,
therefore, will be raising some very important regulatory and market designissues in the
years ahead.
4. Very large US ?nancial institutions
US banking organizations have grown particularly rapidly in recent years. In part this
re?ects deregulationinthe USAthat unwounddepression-erarules whichhadlimitedUS
banks’ domestic geographic reach and range of activities. Indeed, it is almost hard for us
to recall howdifferent USbankingand?nancial markets were onlya fewyears ago. Inthe
years following repeal of such restrictions we have seen consolidation of commercial
banks and investment banks that has transformed the industry in the USA. Many banks
and brokers merged into national or international companies. The largest do business in
multiple markets around the world, and their identities are decreasingly national per se.
Inthe context of global markets andtechnologythat allows or encourages signi?cantly
increased scales and scopes of operation by banks and investment banks, size itself has
become an important factor. Table I lists the biggest US banking organizations, both in
dollars and in comparison with the size of the US economy. While the top few are huge
relative to the economy, it falls off fairlysharply after the top ten. Table II shows estimates
by Acharya et al. of the contribution of US banking organizations to systemic risk,
including both the potential loss of their own assets and their contribution to the loss of
assets at other organizations. While the rankings are not exactly alike, the three top
US banking organizations by size are also the top contributors to systemic risk.
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The interconnectedness of banks is clearly important, but simply their size relative to the
economy is a fundamental factor as well.
Yet, as Table III shows, very large US banking organizations are just catching up in
size with many of the very large non-US banks. What is still not well understood is
whether the US banks pose great potential risks than other banks in the world of
comparable size. The tremendous exposures of US banks to seemingly unrelated but
reputationally dependent entities holding assets off balance sheet clouds the size issue
and makes capital adequacy and liquidity analyses quite tricky.
New rules and regulations
How are the new ?nancial reform legislation and rules on capital requirements likely to
interact with the above trends in markets and institutions? We will focus on the key
new rules that have been prompted or in?uenced by the ?nancial crisis.
Recent and pending reforms are as follows:
(1) Dodd-Frank Wall Street Reform and Consumer Protection Act:
.
Enhanced resolution authority for largest banks.
.
Council of regulators.
.
Diluted “Volcker rule” enhanced role for clearinghouses in over the-counter
(e.g. swap) trading.
.
Consumer protection agency, housed at Fed but independent of Fed.
(2) Base III:
.
Signi?cant increase in minimum capital requirements for large, International
banks.
Bank holding co. Total assets ($bil.) Percent of current dollar GDP
Bank of America Corp. 2,366 16.2
JPMorgan Chase & Co. 2,014 13.8
Citigroup Inc. 1,938 13.3
Wells Fargo & Co. 1,225 8.4
Goldman Sachs Group 883 6.1
Morgan Stanley 809 5.5
Metlife, Inc. 574 3.9
Barclays Group US 356 2.4
Taunus Corp. (Deutsche bank in the USA) 348 2.4
HSBC North America 333 2.3
US Bancorp 283 1.9
PCN Financial 261 1.8
Bank of NY Mellon 235 1.6
Capital One Financial 197 1.4
Ally Financial Inc. 176 1.2
SunTrust Banks 170 1.2
State Street Corp. 160 1.1
TD Bank US Holding Co. 159 1.1
BB&T Corp. 155 1.1
Source: Federal Reserve National Information Center and US Bureau of Economic Analysis; current
dollar GDP for Q2 2010 at seasonally adjusted annual rate ¼ $14,579 billion
Table I.
Size largest US banking
organizations relative US
economy, June 2010
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(3) SEC “Flash crash” rules:
.
Circuit breakers to US equities market, instead of at individual exchanges.
.
Market must halt trading temporarily in all US equities markets, if prices
move 10 percent or more within ?ve minutes.
Enhanced resolution authority
When a very large ?nancial institution gets in trouble now, or if its capital gets so low
that it appears to pose a risk to the ?nancial system, as a practical matter it has been
very hard for regulators to intervene, short of taking over or selling a huge bank. While
bankruptcy avoids a chaotic scramble by creditors it starts a legal process that may be
drawn out or unpredictable. Moreover, large institutions have large exposures to one
another, particularly in the overnight or intraday money markets and in clearing and
settlement of trading activities. Hence, the fact or suspicion of large bank insolvency
can create a withdrawal of investors and depositors, forcing central banks to step in.
The regulators trying to resolve an insolvent or undercapitalized institution are
forced to deal with multiple complex issues. In the event of bankruptcy, a court with
limited familiarity with many of the markets, instruments, and participants involved
must rule on multiple facets of the case, and this may create an unacceptable delay
during which problems can worsen. The Dodd-Frank Act[1] allows the FDICto seize and
liquidate a large bank, broker, insurer, or other ?nancial company upon certi?cation by
the relevant regulatory authorities that:
Asset SRISK (%) MES QLVG MV Vol. Cor. b
Bank of America 19.17 5.13 16.98 120,205.4 28.21 0.75 1.92
JP Morgan Chase 11.54 4.3 13.46 147,305.9 24.95 0.71 1.61
Citigroup 10.13 4.26 15.46 114,445.4 25.39 0.7 1.59
Wells Fargo 9.45 5.05 9.18 123,404 27.21 0.77 1.89
Morgan Stanley 6.88 5.01 21.71 34,952.14 30.24 0.68 1.97
MetLife 4.88 4.97 15.82 35,558.68 28.82 0.72 2.13
Prudential Financial 4.41 5.14 33.47 25,026.29 30.5 0.71 2.1
Goldman Sachs 3.48 4.01 10.67 77,698.19 23.04 0.7 1.59
Hartford Financial Services Group 3.43 5.67 28.11 10,544.85 31.29 0.75 2.23
Lincoln National 2.1 5.91 21.79 7,947.34 33.24 0.74 2.21
Capital One Financial 1.91 5.53 10.33 16,836.65 32.87 0.69 2.18
SLM Corporation 1.86 3.85 37.91 5,449.63 31.48 0.51 1.44
US Bancorp 1.83 4.82 6.8 43,212.76 26.74 0.75 1.8
Suntrust Banks 1.81 5.69 12.06 12,188.38 31.17 0.76 2.13
Genworth Financial 1.69 6.4 16.03 6,420.07 34.83 0.71 2.56
Fifth Third Bancorp 1.38 5.96 10.72 9,659.36 34.78 0.71 2.23
Regions Financial 1.24 5.45 13.86 8,866.94 32.59 0.69 2.04
Principal Financial Group 1.18 4.98 15.73 8,481.82 27.13 0.78 2.05
Keycorp 1.15 5.96 12.39 7,068.66 33.65 0.73 2.23
PNC Financial Services 1.13 4.58 9.3 26,963.5 28.76 0.66 1.71
American Express 1.07 5.01 3.74 47,033.51 37.44 0.56 1.87
Notes: Risk analysis (systemic event: 22% mkt fall); “[. . .] Marginal Expected Shortfall or MES [. . .]
is a prediction of how much the stock of a particular ?nancial company will decline in a day, if the
whole market declines by 2%” (Acharya et al., 2010; NYU Stern Volatility Vlab, 2010)
Table II.
Acharya, Pederson,
Philippon, and
Richardson estimates
of systemic riskiness
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a ?nancial company is in default or at risk of default;
.
its failure and resolution under normal legal procedures would have a negative
impact on the ?nancial stability of the United States (emphasis added); and
.
the FDIC receivership process would avoid or mitigate such adverse effects.
Part of the presumption here appears to be that the troubled ?nancial ?rm is primarily
operating within the USA. For very large multinational institutions, it is certainly
possible that failure would have a signi?cant impact on the functioning of multiple
countries’ ?nancial systems. Therefore, the effectiveness of this prompt resolution
authority for the largest institutions may depend on how internationally synchronized
the regulatory actions are. While the coordination among US regulators and their
increased ability to close an organization is certainly a step forward, it might not be
adequate to handle the prompt resolution of a very large multinational bank failure
affecting many countries simultaneously.
Council of regulators
A closely related issue has been that when a large bank gets into trouble there are so
many different regulators involved. The newlegislation tries to address this by creating
a council of regulators, who will be empowered to exchange con?dential information to
help prevent or resolve problems. Realistically, because the US regulation system has
been fragmented for years, regulators have already had to learn to work together, but the
council may be a step forward.
Again, however, it should be noted that coordination among regulators within
the USA is insuf?cient. Internationally active ?nancial institutions that appear
BNP 2,961
RBS Group 2,747
HSBC Holdings 2,364
Credit Agricole 2,243
Barclays 2,233
Bank of Amercia 2,223
Mitsubishi UFJ Fin 2,196
Deutsche Bank 2,162
JPMorgan Chase 2,032
Citigroup 1,857
Indus&Com Bk Chin 1,726
ING Group, Netherlds 1,676
Lloyds Banking Grp 1,664
Mizuho Fin Group 1,637
Banco Santander 1,600
Group BPCE 1,482
Soc Generale 1,475
China Construction Bk. 1,409
Unicredit 1,338
Ag. Bank of China 1,301
UBS 1,301
Notes: Mitsubishi and Mitzuho as of 31 March 2010; assets in billions of US dollars
Source: Global Finance, September 2010
Table III.
Assets of largest banks in
the world, as of end-2009
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to be “too big to fail” are linked into ?nancial markets globally. Because their decisions
on locating businesses can have a big impact on ?nancial centers, the largest banks
might in?uence local regulators. While well-regulated ?nancial markets are generally
good for participants, there are typically ways of implementing rules that impact
participants differentially. Regulatory competition in laxity in response to threats large
internationally active banking organizations is one risk[2]. The jury is still out on
whether or not the council of regulators will actually help coordinate the supervision
process within the USA, or whether its role becomes more focused over coordinating
actions between non-US regulators and the cluster of US regulators.
Diluted “Volcker rule”
Another part of the new regulation will be restrictions on using a bank’s own capital to
take large speculative positions in securities or loans. This so-called Volcker rule limits
banks’ proprietary trading, hedge fund ownership, and private equity investments to
3 percent of their capital. Banks will also be able to take positions in the provision of
market making services to clients. Perhaps, not surprisingly, the original version of the
rule was stronger, re?ecting former Fed Chairman Paul Volcker’s original
recommendation to prohibit proprietary trading by the largest banks.
A complication is that the risks associated with market making by banks and
securities dealers are sometimes quite unpredictable. In normal times, a dealer can make
markets and control risk by varying the terms he or she offers to the market.
The ever-present risk in such operations is that the dealer will not be among the ?rst to
learn of developments impacting market conditions, and so will end up buying before
prices fall and selling before prices rise, in response to customer initiative. Even if the
dealer’s normal procedure is to keep as low an exposure to the market as feasible, there
will be times when the dealer loses money. Overall, the dealer business implies that
spreads and fees to customers plus opportunities to pro?t from his own informational
and liquidity advantages generate enough revenue to make up for the losses. But the net
pro?tability can be volatile, particularly in volatile markets. An inept dealer can lose a
large amount of money, simply in the process of accommodating knowledgeable
customers. In short, it would be unrealistic to presume that dealer banks’ capital can be
fully insulated from market movements, and the new legislation implicitly
acknowledges that trading risk will remain with the dealer banks.
Increased role for clearinghouses
An increased role for ?nancial clearinghouses is a welcome feature of the new
legislation, although, like the Volcker rule it ended up being weakened in the ?nal
version. Clearinghouses are tried and true mechanisms in regulated exchanges, whereby
traders have to put up margin funds in proportion to the trading risks they are taking.
Currently, however, much of the trading in risky securities and derivatives contracts
occurs off of organized exchanges, in the so-called over-the-counter markets. These
markets generally involve bilateral transactions between traders and dealers and lack
some of the safeguards seen in regulated exchanges. The clearinghouse structure should
help. Even if a trader loses all his money, the funds or collateral he has already deposited
through his broker at the clearing house generally should cover his losses, so that the
people he lost the money to will get paid.
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A problem has been that the over-the-counter market is where the credit default
swaps and other relatively new, untested instruments have been trading, and these
markets have grown huge in recent years. Given their dependence on dealers rather than
exchanges to connect buyers and sellers, and given the large exposures of sellers of
credit protection, the risks in this market have become very palpable. Now everyone
recognizes that a better system is needed. While some had advocated moving this
trading onto organized exchanges, and the increased role for clearinghouses is the
legislative compromise.
Of course, this role for clearinghouses raises the question of whether a clearinghouse
itself could fail. How much margin or capital should back a clearinghouse that stands
behind contracts on credit guarantees or other complicated derivatives? Given the
nature of credit, that could be a very large amount of required capital, depending how
safe the clearinghouse needs to be. Even the possibility of failure of a clearinghouse
during a crisis would be a signi?cant accelerant of market problems. During 1987, for
example, the Federal Reserve pressured participants in securities and futures markets
clearing to keep credit and cash ?owing in the settlement process, to avoid further
destructive selling.
By forcing bilateral trades to be cleared and settled through a larger clearing house,
the settlement risk exposures are collectivized among the clearinghouse members.
The larger the number of participants in the clearinghouse, the stronger it becomes
in general, since the likelihood is that winning and losing positions will net out in the
aggregate. Nevertheless, someone trying to circumvent the spirit of these rules could in
principle set up very targeted, small clearinghouses with little capital to back trades.
One of the jobs of regulators actually making the rules to implement this legislation,
therefore, will be to do so in a way that really reduces the odds that the US treasury will
gain feel compelled to bail out speculators.
Basel III
Another key set of rules is the international agreement on minimum bank capital
ratios, agreed to in September 2010 at the Bank for International Settlements in Basel,
Switzerland, by a large number of national bank regulators. Minimum capital
requirements have become risk based and hence have quickly become complex. But the
agreement will raise these minima relative to what they have been[3].
Given the long eight-year phase-in, many informed observers would have preferred
to see capital ratios closer to 15 or 20 percent. Indeed, the hesitation by regulators to
raise capital requirements faster or more aggressively may re?ect the political
in?uence of the regulated ?rms on the process. Intellectually, there appears to be a
confounding of different concerns. As ?nance theory tells us, the lower the leverage,
the less risky will be the ?rm, other factors equal, and hence presumably the less costly
would be its capital. In its simplest form, this “Miller Modigliani” view of capital
arguably ignores the fact that it is costly and time consuming for potential equity
investors to learn what they need to know to allow an organization to signi?cantly
shift its capital structure toward more equity. Moreover, in the short run attempting to
raise a great deal of capital would con?ict with large bank management’s objectives to
pay dividends to shareholders and bonuses.
Nevertheless, the eight-year phase-in period allowed by the Basel III rules would
appear to accommodate a large increase in capital while making huge compensation
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packages possible. If in eight years a bank cannot raise that much capital from
investors, then that is likely be a clear market signal that it needs to shrink.
One measure of the usefulness of international minimumcapital requirements is how
satisfactory they are to the various national regulators. Setting too low an international
minimum would amount to relegating capital decisions back to each country. For
example, after Basel II, the USAimplemented a version with a higher core equity capital
ratio requirement for bank holding companies than was agreed internationally.
Although Basel III raised minimum equity requirements signi?cantly, some country
regulators such as the Swiss, are opting for signi?cantly higher capital minima.
Flash crash
On May 6, 2010 US equity trading was interrupted by problematic interactions of
automated trading and execution systems. This incident grabbed headlines because of
its demoralizing effects on already weak equity markets in the recessionary economy
(SEC and CFTC joint report, 2010). Early crashes related to computer guided trading or
systems problems have occurred episodically since the 1987 “market break”[4]. The
so-called “Flash crash” of 2010 was apparently precipitated by a clumsy large equity
order submission and by the extremely fast but uncoordinated actions of competing
execution systems. In part, the vulnerability of US equity trading markets to such an
occurrence was enhanced by the fragmentation of equity markets, a trend encouraged
by the US SEC, which had aggressively promoted market competition and innovation
without as much attention to its effects on market integrity under stress. While the
NYSE had developed automatic trading pauses designed to allow liquidity to be rebuilt
in the face of sudden price movements in individual shares, other markets had not been
required to do so. When a pause occurred on the NYSE, therefore, orders were rapidly
redirected to competing, unpaused trading platforms, some of which could not handle
the volume surges. As a result, nonsensical prices – from very high to nearly zero –
were generated, and many trades later had to be cancelled.
The SEC subsequently enacted rules that required trading of a security in all US
markets to pause when prices changed by 10 percent or more on the main listing market.
But these beg some important questions. One issue not addressed was the trading of
stocks outside the USA. While the need for liquidity tends to concentrate trading during
periods when markets are open, there is considerable overlap in the trading days of
Europe and North America. A halt of competing trading systems could create
opportunities for unregulated platforms and could disadvantage investors without
immediate access to ongoing trading. Therefore, for trading halts to be both effective
and fair, they must be coordinated not only within the USA but also internationally.
Because many stocks trade in multiple countries, broader international coordination of
rules in this type of case may become necessary.
A second issue left unaddressed is the de?nition of a stock’s main listed market.
Many stocks that are listed on a major stock exchange trade at least as actively on
competitor platforms. Many such competitors tailor fee structures and trading protocols
to attract particular groups of traders. As a result, the main stock exchange where a
company pays to list may not be where the most liquid trading in its shares can be found.
In short, it seems clear that the contention and episodic confusion in markets created
by multiple high-volume trading engines will continue to be a key policy issue going
forward. Hopefully, investors will be able to distinguish between technical
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coordination problems and more fundamental factors affecting market values. At the
heart of the problem is the need by individual investors to make decisions and trade
very rapidly, not because of the in?ow of information exogenous to the markets but
rather because of the need to be faster than competitors, even in the realm of
micro-millisecond trading. Also at the heart of the problem is the need for leadership
and informed oversight by regulators.
Conclusions
Globalization and technical change are combining to encourage large institutions and
more complex, faster trading technologies. The process is expanding to affect markets
all over the world. Mergers and alliances may create ever larger global ?nancial
institutions in the coming years. Indeed, it seems inevitable that, particularly as large
banks grow in emerging markets like Brazil, China, Russia, and other fast-expanding
economies, we will see a larger number of even bigger, more globalized banks and
investment banks than we now have. The issue of too big to fail and the problems
associated with the mismatch in size and capability between global banks and national
regulators appears likely to continue. In short, ?nancial markets during the next few
years will continue to grow more complex, interconnected and global, and with bigger
institutions. On top of all that, the technologies being brought to bear in trading place a
very high value on speedy – and hence computer-guided – actions, which means that
markets can become unstable in the blink of an eye. The question is whether
governments are up to the challenge of coordinating efforts to manage the risks,
challenges, and opportunities these organizations and technologies will present.
Notes
1. Dodd-Frank Wall Street Reform and Consumer Protection Act.
2. For example, one major international ?nancial news daily reported that, “Lloyd Blankfein,
chief executive of Goldman Sachs, has issued a clear warning that the bank could shift its
operations around the world if the regulatory crackdown becomes too tough in certain
jurisdictions” Financial Times, 30 September 2010, p. 1.
3. See Blinder (2010) for a brief summary and critique of the Basel III capital rules.
4. See “Brady Report” Presidential Task Force on Market Mechanisms (1988).
References
Acharya, V.V. and Richardson, M. (Eds) (2009), Restoring Financial Stability, How to Repair a
Failed System, NYU Stern/Wiley Finance, New York, NY.
Acharya, V.V., Cooley, T., Richardson, M.P. and Walter, I. (2010a), Regulating Wall St, The Dodd
Frank Act and the New Architecture of Global Finance, NYU Stern/Wiley Finance,
New York, NY.
Acharya, V.V., Pederson, L.H., Philippon, T. and Richardson, M. (2010b), “Measuring systemic
risk”, NYU Stern working paper, May.
Angel, J.J., Harris, L.E. and Spatt, C.S. (2010), Equity Trading in the 21st Century, Knight Capital
Group, Jersey City, NJ.
Blinder, A.S. (2010), “Two cheers for the new bank capital standards”, Wall Street Journal,
September 30, p. A25.
The (revised)
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?nancial markets
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“Brady Report” Presidential Task Force on Market Mechanisms (1988), Report of the
Presidential Task Force on Market Mechanisms, submitted to the President of
the United States, the Secretary of the Treasury, and the Chairman of the Federal
Reserve Board, US Government Printing Of?ce, Washington, DC.
Greene, E.F., Mcllwain, K.L. and Scott, J.T. (2010), “A closer look at ‘too big to fail’: national and
international approaches to addressing the risks of large, interconnected ?nancial
institutions”, Capital Markets Law Journal, Vol. 5 No. 2.
Janovic, B. and Menkveld, A.J. (2010), “Middlemen in limit-order markets”, working paper.
NYU Stern Volatility Vlab (2010), “NYU Stern systemic risk rankings”, NYU Stern working paper,
May, available at:http://vlab.stern.nyu.edu/analysis/RISK.USFIN-MR.MES
(The) Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission
(CFTC) (2010), “Findings regarding the markets events of May 6”, Report of the Staffs of
the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues,
US Commodity Futures Trading Commission and US Securities & Exchange Commission,
September 30.
Further reading
Lo, A.W. (2008), Hedge Funds: An Analytic Perspective, Princeton University Press, Princeton, NJ.
Corresponding author
Paul Bennett can be contacted at: [email protected]
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This article has been cited by:
1. Olukorede Eliza Abioye, Babis Theodoulidis, George Dimitrkopoulos, Nikolaos, Stuart Hyde, David
DiazManaging Risks in Financial Markets: A Market Simulation Approach 75-86. [CrossRef]
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doc_158892215.pdf
The purpose of this paper is to evaluate recent financial system reforms in the USA by
placing them in the context of major structural trends currently underway in the markets, due to
technology and globalization of trading.
Journal of Financial Economic Policy
The (revised) future of financial markets
Paul Bennett
Article information:
To cite this document:
Paul Bennett, (2011),"The (revised) future of financial markets", J ournal of Financial Economic Policy, Vol. 3
Iss 2 pp. 109 - 122
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The (revised) future
of ?nancial markets
Paul Bennett
Rutgers University, Newark, New Jersey, USA
Abstract
Purpose – The purpose of this paper is to evaluate recent ?nancial system reforms in the USA by
placing them in the context of major structural trends currently underway in the markets, due to
technology and globalization of trading.
Design/methodology/approach – The paper describes trends underway in markets and
examines how the new rules recently agreed to in the USA and among regulators globally will
bear on them.
Findings – The paper ?nds that the ?nancial system reforms in the USA can be expected to have
modest bene?cial effects in terms of making markets more robust and ef?cient, and that key trends
affecting markets need to be taken into account as regulators implement the new rules and evaluate
the need for future amendments. Our ?ndings imply that regulators should be willing to closely
monitor the reforms and adjust them quickly as needed.
Originality/value – This article adds the perspective of interacting key secular trends in the
structure of the banking and ?nancial system with the latest regulatory initiatives.
Keywords Economic reform, International trade, Banking, Financial institutions,
United States of America
Paper type Research paper
Introduction
The 2007-2009 crisis in US ?nancial markets not only stimulated new legislation and
capital rules for restoring order and con?dence to markets, but it also highlighted
underlying trends in ?nancial markets that will persist and continue to affect economic
and ?nancial policies going forward. Although public discussion has been intense, the
academic literature analyzing the crisis is still developing. Acharya and Richardson
(2009) compiled a volume of papers that suggested needed reforms even before the crisis
had leveled off, and Acharya et al. (2010a, b) compiled descriptions and critique of
the regulations emerging from the Dodd-Frank and other legislation. Angel et al. (2010)
provide a monogram describing some of the key structural changes to equities markets
leading up to and through the crisis. The Securities and Exchange Commission (SEC)
and Commodity Futures Trading Commission (CFTC) (2010) provide their own
description of the “?ash crash” episode that so enervated markets in the post-crash
months, although their analysis does not address the roles of ?nancial regulation in
allowing the systemto become so fragile. Greene et al. (2010) have provided a thoughtful
discussion of the challenges of regulating global organizations using national-level
authority.
This article attempts to distill some of the most important outcomes of the crisis and
subsequent legislation on the dynamic structure of ?nancial markets going forward.
It ?rst identi?es several important, largely technology-driven trends in market
structures, and then it analyzes how the crisis and associated regulation may be
in?uencing such trends, if at all. The trends are:
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
The (revised)
future of
?nancial markets
109
Journal of Financial Economic Policy
Vol. 3 No. 2, 2011
pp. 109-122
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381111133598
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the continuing globalization and cross-border integration of ?nancial markets;
.
the growth of technologies that help integrate large institutions and, in the process,
increase the returns to scale and scope in banking and investment banking;
.
the introduction of technologies that permit very rapid trading strategies,
including automated trading systems designed to give their users ?rst-mover
advantages relative to other traders; and
.
the increasing presence in multiple markets around the world of very large
?nancial institutions – sometimes dubbed “to big to fail” – that often appear at
least as technologically and politically savvy as the many national-level
regulators, lawmakers, and central banks charged with supervising them.
Froma policy perspective, initiatives such as the newBIS minimumcapital requirements
agreement, the Dodd-Frank reform legislation, and new SEC rules designed to prevent
technology-driven market volatility are reactions to these trends yet appear unlikely to
fundamentally alter them, in part because the affected institutions have been successful at
in?uencing the shape of the regulatory change to limit its impact on their own prospects.
This article ?rst discusses these underlying structural trends in more detail. Next it
highlights selected key provisions of the Dodd-Frank, Basel III, and SEC “Flash crash”
rules that interact with the four trends. While many details of how the new rules will be
implemented are still to be determined, it is nonetheless possible to make some
assessments of how they will in?uence market functioning. The article also notes areas
where more reforms may yet need to be considered.
Four structural trends
1. Globalization and cross-border integration of markets
While diversi?cation by US investors is an old story, the expansion of US international
portfolios has continued (Figure 1), especially outside Western Europe and Japan. This
has been both a result of and re?ected by the large amount of public securities
offerings being made available even in markets that previously were closed to outside
investors or less active (Figure 2). As a result, the de?nition of global markets has
expanded for US investors, and the interdependence of market places has become
stronger. A drop in asset prices in one market can affect the ability of banks to continue
to be effective in another. This increases the reactions of markets in one economy to
seemingly unrelated shocks elsewhere.
Figure 1.
Cross US-border equity
holdings 1997-Q2 2007
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1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Q2
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US holdings of foreign stocks Foreign holdings of US stocks
Source: Federal reserve flow of funds
$
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2. Technology-driven economies of scale and scope
Powerful computers and communications are certainly not new. But as innovations have
piledupon innovations andadvancedapplications have become ubiquitous, fundamental
changes have occurred in our banking and ?nancial markets. Data processing systems
have been integrated, allowing near real-time feedback and control over ?rm processes
and risk taking. The art of merging existing systems has also advanced. As a result,
managements of large ?nancial institutions have been able to expand the size their
organizations with more con?dence and effectiveness than previously.
This has allowed some companies to operate on a signi?cantly larger scale. One
example is the expansionof USbanks nationwide inthe wake of the relaxationof interstate
banking. The business of integrating disparate subsidiaries and branches became its own
line of business. The success of organizations in this endeavor helped embolden those
trying to integrate global ?nancial organizations, or to integrate traditional banking and
securities lines as depression-era separations were relaxed. Banks have lent internationally
for decades, and securities have been issued across borders since markets began. But the
ability to control global operations in something closer to real time has encouraged some
ambitious organizations to signi?cantly widen their scopes of operation.
Although the largest ?nancial institutions have been operating on a global scale,
regulation of these organizations has remained ?rmly a national-level responsibility.
While much public-sector effort has been expended trying to coordinate key regulations
such as minimumcapital requirements or accounting rules, the results have been mixed.
For example, while the Basel I minimum capital agreement in the wake of the 1980s
global lending ?asco signalized a good ?rst effort, the Basel II standards were extremely
slow in coming and failed to prevent the recent ?nancial crisis. It is unsurprising that in
some countries the capital rules were not uniformly enforced. For example, in the USA,
large ?nancial holding companies that avoided owning depository institutions escaped
with much lower capital requirements until very recently. Conversely, other regulators
have placed standards on their banks that are stricter than those internationally agreed.
Figure 2.
Corporate initial public
equity offerings by
country of issuer
Other
Asia/Pacific
$17B
Rest of Europe and Mid-East
$54B
USA
$42B
China
$36B
Other Americas
$13B
UK
$15B
Russia
$10B
India
$9B
Brazil
$20B
Source: January-September 2007
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3. Technologies allowing extremely rapid trading
A particularly notable effect of technology on trading in ?nancial markets has been to
speed up order and trade information data transmission, as well as to automate many
trading strategies ( Janovic and Menkveld, 2010). In the ?rst instance, many human
traders have been eliminated and replaced by automated systems. Automated systems
can now make routine trading decisions and make them much faster. Such systems
also allow integrated with back-of?ce automation. The goal of this automation can be
largely understood as attempts to slash costs by replacing people with machines. Some
systems take large orders, strategically break them into pieces, and select the most
appropriate trading platforms for them.
Others forms of automation go a step further, integrating these order routing and
execution capabilities with computer-driven identi?cation of trading opportunities and
security selection. Such automation has been most prevalent in USA and European
equities and equity derivatives. The earliest versions of these were cash-futures and other
arbitrage trades, where costs must be low and speed is essential to trader pro?tability.
More trading based on extrapolative or regressive price projections, automated stock
selections, and other methods continue to spread. These have started in the USA and
spread to Europe, but given the global nature of institutions and markets, it is likely that
very fast computerized trading methods will be applied to more instruments in more
markets, going forward. Therefore, we should be watching closely what works and what
does not in automated US equity markets, for these may foreshadow global trading
methods and patterns in multiple types of instruments and in more markets.
As the role of humans in carrying out trading mechanics has shrunk, and as electronic
trading has risen, one consequence that was not initially foreseen was the competition in
trading system speed that resulted. Human traders have long appreciated the need to
make decisions andact very quickly, inorder to submit orders ahead of other traders. As a
result, theyhave continuedto invest infaster andfaster decisionmakingandtransmission
systems, while exchanges and other platforms have invested heavily to keep up. With
natural physical limits on transmission speed beginning to bind, traders have begun to
compete for transaction speed by placing their machines closer and closer to exchanges.
One way to increase the speed of algorithms is to streamline or eliminate some of the
internal checks or safeguards that would normally prevent nonsensical orders being
submitted, with resultant trading glitches or worse. In the process, these systems and
their interaction in electronic markets have created market prices that sometimes move
faster than humans can mentally track. As news becomes incorporated in public price
quotes and trades even before many participants in the market are aware of the news
itself, the demand for speed is multiplied among traders.
Figure 3 shows the dramatic and ongoing trend in the speed with which orders are
submitted and executed, and the fastest trades now occur are completed in a few
milliseconds. When a human being, whether a trader, exchange operators, or regulator,
recognizes that trading engines have gone seriously haywire, it may already be too late
to avoid a signi?cant disruption in a market’s functioning.
A closely related contribution of computerization of trading has been sharply falling
trade execution costs (Figure 4). This includes not only the transactions fees levied by
brokers and exchanges but also and more signi?cantly the market impact of trades, at
least under normal market conditions, since trading algorithms are typically designed
to submit even large orders in smaller, randomized pieces to lessen their impact on
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market prices. The rising speed and falling marginal transactions costs are of a piece
because they both result from competitive use of automated systems to cut costs and
gain trading advantages.
Automatedsystems provide negligible marginal costs per trade but require substantial
development. As competitors are able to catch up or surpass a trading system, resources
must be continually committed to upgrading systems. As noted, certain functions such as
risk management systems are also in competition with transaction speed within
algorithms, and so it is not surprising that the role of coordinating and regulating the
contention these systems generate in public trading has been left to exchanges and other
Figure 3.
Execution speed,
NYSE equities
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Figure 4.
Falling order execution
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trading platforms. These businesses, in turn, are similarly under sharp competitive
competition. Regulators have been at a distinct disadvantage in playing traf?c-cop in this
new world of electronic markets both because of a lack of resources and knowledge, and
have also been reluctant to intervene in the very complex and rapidly evolving electronic
marketplace. Interventions have therefore tended to reacte to problems rather than be
pre-emptive.
Closely related to the speed and very low marginal trading costs has been the
fragmentation of trading among competing platforms. This has been particularly
evident in US equities trading, where traditional NewYork Stock Exchange (NYSE) and
NASDAQ shares of execution and trading reporting volumes plummeted from nearly
90 percent or more of listed market shares to well under half within the space of a decade.
Fragmented systems emphasize competition, which has helped lower costs and raise
speed. But the competitive pressures among competing markets have also taken away
incentives or individual trading venues to maintain resilient mechanisms for protecting
against trading problems that could spill over into the larger market (Angel et al., 2010).
This became particularly evident in the “Flash Crash” of May 2010, when a ?ood of
orders triggered automatic circuit breakers in part of the market, causing the orders to
spill over or be automaticallyredirectedto alternative exchanges or platforms (CFTCand
SEC, September 2010). In the process, many systems became momentarily overloaded,
and the market stopped functioning effectively, spewing nonsensical prices and trades.
Goingforward, it is virtuallycertainthat computers will continue to increase their role
in market trading, and competitors will develop faster and more complex technologies
for trading. So far, these systems have been largely con?ned to the US equities markets.
But they give such an important speed advantage in decision making, in communication
of trading instructions, and in data transmission that they will surely become more
prevalent in equity, ?xed income, and derivatives markets globally. The “?ash-crash”,
therefore, will be raising some very important regulatory and market designissues in the
years ahead.
4. Very large US ?nancial institutions
US banking organizations have grown particularly rapidly in recent years. In part this
re?ects deregulationinthe USAthat unwounddepression-erarules whichhadlimitedUS
banks’ domestic geographic reach and range of activities. Indeed, it is almost hard for us
to recall howdifferent USbankingand?nancial markets were onlya fewyears ago. Inthe
years following repeal of such restrictions we have seen consolidation of commercial
banks and investment banks that has transformed the industry in the USA. Many banks
and brokers merged into national or international companies. The largest do business in
multiple markets around the world, and their identities are decreasingly national per se.
Inthe context of global markets andtechnologythat allows or encourages signi?cantly
increased scales and scopes of operation by banks and investment banks, size itself has
become an important factor. Table I lists the biggest US banking organizations, both in
dollars and in comparison with the size of the US economy. While the top few are huge
relative to the economy, it falls off fairlysharply after the top ten. Table II shows estimates
by Acharya et al. of the contribution of US banking organizations to systemic risk,
including both the potential loss of their own assets and their contribution to the loss of
assets at other organizations. While the rankings are not exactly alike, the three top
US banking organizations by size are also the top contributors to systemic risk.
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The interconnectedness of banks is clearly important, but simply their size relative to the
economy is a fundamental factor as well.
Yet, as Table III shows, very large US banking organizations are just catching up in
size with many of the very large non-US banks. What is still not well understood is
whether the US banks pose great potential risks than other banks in the world of
comparable size. The tremendous exposures of US banks to seemingly unrelated but
reputationally dependent entities holding assets off balance sheet clouds the size issue
and makes capital adequacy and liquidity analyses quite tricky.
New rules and regulations
How are the new ?nancial reform legislation and rules on capital requirements likely to
interact with the above trends in markets and institutions? We will focus on the key
new rules that have been prompted or in?uenced by the ?nancial crisis.
Recent and pending reforms are as follows:
(1) Dodd-Frank Wall Street Reform and Consumer Protection Act:
.
Enhanced resolution authority for largest banks.
.
Council of regulators.
.
Diluted “Volcker rule” enhanced role for clearinghouses in over the-counter
(e.g. swap) trading.
.
Consumer protection agency, housed at Fed but independent of Fed.
(2) Base III:
.
Signi?cant increase in minimum capital requirements for large, International
banks.
Bank holding co. Total assets ($bil.) Percent of current dollar GDP
Bank of America Corp. 2,366 16.2
JPMorgan Chase & Co. 2,014 13.8
Citigroup Inc. 1,938 13.3
Wells Fargo & Co. 1,225 8.4
Goldman Sachs Group 883 6.1
Morgan Stanley 809 5.5
Metlife, Inc. 574 3.9
Barclays Group US 356 2.4
Taunus Corp. (Deutsche bank in the USA) 348 2.4
HSBC North America 333 2.3
US Bancorp 283 1.9
PCN Financial 261 1.8
Bank of NY Mellon 235 1.6
Capital One Financial 197 1.4
Ally Financial Inc. 176 1.2
SunTrust Banks 170 1.2
State Street Corp. 160 1.1
TD Bank US Holding Co. 159 1.1
BB&T Corp. 155 1.1
Source: Federal Reserve National Information Center and US Bureau of Economic Analysis; current
dollar GDP for Q2 2010 at seasonally adjusted annual rate ¼ $14,579 billion
Table I.
Size largest US banking
organizations relative US
economy, June 2010
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(3) SEC “Flash crash” rules:
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Circuit breakers to US equities market, instead of at individual exchanges.
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Market must halt trading temporarily in all US equities markets, if prices
move 10 percent or more within ?ve minutes.
Enhanced resolution authority
When a very large ?nancial institution gets in trouble now, or if its capital gets so low
that it appears to pose a risk to the ?nancial system, as a practical matter it has been
very hard for regulators to intervene, short of taking over or selling a huge bank. While
bankruptcy avoids a chaotic scramble by creditors it starts a legal process that may be
drawn out or unpredictable. Moreover, large institutions have large exposures to one
another, particularly in the overnight or intraday money markets and in clearing and
settlement of trading activities. Hence, the fact or suspicion of large bank insolvency
can create a withdrawal of investors and depositors, forcing central banks to step in.
The regulators trying to resolve an insolvent or undercapitalized institution are
forced to deal with multiple complex issues. In the event of bankruptcy, a court with
limited familiarity with many of the markets, instruments, and participants involved
must rule on multiple facets of the case, and this may create an unacceptable delay
during which problems can worsen. The Dodd-Frank Act[1] allows the FDICto seize and
liquidate a large bank, broker, insurer, or other ?nancial company upon certi?cation by
the relevant regulatory authorities that:
Asset SRISK (%) MES QLVG MV Vol. Cor. b
Bank of America 19.17 5.13 16.98 120,205.4 28.21 0.75 1.92
JP Morgan Chase 11.54 4.3 13.46 147,305.9 24.95 0.71 1.61
Citigroup 10.13 4.26 15.46 114,445.4 25.39 0.7 1.59
Wells Fargo 9.45 5.05 9.18 123,404 27.21 0.77 1.89
Morgan Stanley 6.88 5.01 21.71 34,952.14 30.24 0.68 1.97
MetLife 4.88 4.97 15.82 35,558.68 28.82 0.72 2.13
Prudential Financial 4.41 5.14 33.47 25,026.29 30.5 0.71 2.1
Goldman Sachs 3.48 4.01 10.67 77,698.19 23.04 0.7 1.59
Hartford Financial Services Group 3.43 5.67 28.11 10,544.85 31.29 0.75 2.23
Lincoln National 2.1 5.91 21.79 7,947.34 33.24 0.74 2.21
Capital One Financial 1.91 5.53 10.33 16,836.65 32.87 0.69 2.18
SLM Corporation 1.86 3.85 37.91 5,449.63 31.48 0.51 1.44
US Bancorp 1.83 4.82 6.8 43,212.76 26.74 0.75 1.8
Suntrust Banks 1.81 5.69 12.06 12,188.38 31.17 0.76 2.13
Genworth Financial 1.69 6.4 16.03 6,420.07 34.83 0.71 2.56
Fifth Third Bancorp 1.38 5.96 10.72 9,659.36 34.78 0.71 2.23
Regions Financial 1.24 5.45 13.86 8,866.94 32.59 0.69 2.04
Principal Financial Group 1.18 4.98 15.73 8,481.82 27.13 0.78 2.05
Keycorp 1.15 5.96 12.39 7,068.66 33.65 0.73 2.23
PNC Financial Services 1.13 4.58 9.3 26,963.5 28.76 0.66 1.71
American Express 1.07 5.01 3.74 47,033.51 37.44 0.56 1.87
Notes: Risk analysis (systemic event: 22% mkt fall); “[. . .] Marginal Expected Shortfall or MES [. . .]
is a prediction of how much the stock of a particular ?nancial company will decline in a day, if the
whole market declines by 2%” (Acharya et al., 2010; NYU Stern Volatility Vlab, 2010)
Table II.
Acharya, Pederson,
Philippon, and
Richardson estimates
of systemic riskiness
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a ?nancial company is in default or at risk of default;
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its failure and resolution under normal legal procedures would have a negative
impact on the ?nancial stability of the United States (emphasis added); and
.
the FDIC receivership process would avoid or mitigate such adverse effects.
Part of the presumption here appears to be that the troubled ?nancial ?rm is primarily
operating within the USA. For very large multinational institutions, it is certainly
possible that failure would have a signi?cant impact on the functioning of multiple
countries’ ?nancial systems. Therefore, the effectiveness of this prompt resolution
authority for the largest institutions may depend on how internationally synchronized
the regulatory actions are. While the coordination among US regulators and their
increased ability to close an organization is certainly a step forward, it might not be
adequate to handle the prompt resolution of a very large multinational bank failure
affecting many countries simultaneously.
Council of regulators
A closely related issue has been that when a large bank gets into trouble there are so
many different regulators involved. The newlegislation tries to address this by creating
a council of regulators, who will be empowered to exchange con?dential information to
help prevent or resolve problems. Realistically, because the US regulation system has
been fragmented for years, regulators have already had to learn to work together, but the
council may be a step forward.
Again, however, it should be noted that coordination among regulators within
the USA is insuf?cient. Internationally active ?nancial institutions that appear
BNP 2,961
RBS Group 2,747
HSBC Holdings 2,364
Credit Agricole 2,243
Barclays 2,233
Bank of Amercia 2,223
Mitsubishi UFJ Fin 2,196
Deutsche Bank 2,162
JPMorgan Chase 2,032
Citigroup 1,857
Indus&Com Bk Chin 1,726
ING Group, Netherlds 1,676
Lloyds Banking Grp 1,664
Mizuho Fin Group 1,637
Banco Santander 1,600
Group BPCE 1,482
Soc Generale 1,475
China Construction Bk. 1,409
Unicredit 1,338
Ag. Bank of China 1,301
UBS 1,301
Notes: Mitsubishi and Mitzuho as of 31 March 2010; assets in billions of US dollars
Source: Global Finance, September 2010
Table III.
Assets of largest banks in
the world, as of end-2009
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to be “too big to fail” are linked into ?nancial markets globally. Because their decisions
on locating businesses can have a big impact on ?nancial centers, the largest banks
might in?uence local regulators. While well-regulated ?nancial markets are generally
good for participants, there are typically ways of implementing rules that impact
participants differentially. Regulatory competition in laxity in response to threats large
internationally active banking organizations is one risk[2]. The jury is still out on
whether or not the council of regulators will actually help coordinate the supervision
process within the USA, or whether its role becomes more focused over coordinating
actions between non-US regulators and the cluster of US regulators.
Diluted “Volcker rule”
Another part of the new regulation will be restrictions on using a bank’s own capital to
take large speculative positions in securities or loans. This so-called Volcker rule limits
banks’ proprietary trading, hedge fund ownership, and private equity investments to
3 percent of their capital. Banks will also be able to take positions in the provision of
market making services to clients. Perhaps, not surprisingly, the original version of the
rule was stronger, re?ecting former Fed Chairman Paul Volcker’s original
recommendation to prohibit proprietary trading by the largest banks.
A complication is that the risks associated with market making by banks and
securities dealers are sometimes quite unpredictable. In normal times, a dealer can make
markets and control risk by varying the terms he or she offers to the market.
The ever-present risk in such operations is that the dealer will not be among the ?rst to
learn of developments impacting market conditions, and so will end up buying before
prices fall and selling before prices rise, in response to customer initiative. Even if the
dealer’s normal procedure is to keep as low an exposure to the market as feasible, there
will be times when the dealer loses money. Overall, the dealer business implies that
spreads and fees to customers plus opportunities to pro?t from his own informational
and liquidity advantages generate enough revenue to make up for the losses. But the net
pro?tability can be volatile, particularly in volatile markets. An inept dealer can lose a
large amount of money, simply in the process of accommodating knowledgeable
customers. In short, it would be unrealistic to presume that dealer banks’ capital can be
fully insulated from market movements, and the new legislation implicitly
acknowledges that trading risk will remain with the dealer banks.
Increased role for clearinghouses
An increased role for ?nancial clearinghouses is a welcome feature of the new
legislation, although, like the Volcker rule it ended up being weakened in the ?nal
version. Clearinghouses are tried and true mechanisms in regulated exchanges, whereby
traders have to put up margin funds in proportion to the trading risks they are taking.
Currently, however, much of the trading in risky securities and derivatives contracts
occurs off of organized exchanges, in the so-called over-the-counter markets. These
markets generally involve bilateral transactions between traders and dealers and lack
some of the safeguards seen in regulated exchanges. The clearinghouse structure should
help. Even if a trader loses all his money, the funds or collateral he has already deposited
through his broker at the clearing house generally should cover his losses, so that the
people he lost the money to will get paid.
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A problem has been that the over-the-counter market is where the credit default
swaps and other relatively new, untested instruments have been trading, and these
markets have grown huge in recent years. Given their dependence on dealers rather than
exchanges to connect buyers and sellers, and given the large exposures of sellers of
credit protection, the risks in this market have become very palpable. Now everyone
recognizes that a better system is needed. While some had advocated moving this
trading onto organized exchanges, and the increased role for clearinghouses is the
legislative compromise.
Of course, this role for clearinghouses raises the question of whether a clearinghouse
itself could fail. How much margin or capital should back a clearinghouse that stands
behind contracts on credit guarantees or other complicated derivatives? Given the
nature of credit, that could be a very large amount of required capital, depending how
safe the clearinghouse needs to be. Even the possibility of failure of a clearinghouse
during a crisis would be a signi?cant accelerant of market problems. During 1987, for
example, the Federal Reserve pressured participants in securities and futures markets
clearing to keep credit and cash ?owing in the settlement process, to avoid further
destructive selling.
By forcing bilateral trades to be cleared and settled through a larger clearing house,
the settlement risk exposures are collectivized among the clearinghouse members.
The larger the number of participants in the clearinghouse, the stronger it becomes
in general, since the likelihood is that winning and losing positions will net out in the
aggregate. Nevertheless, someone trying to circumvent the spirit of these rules could in
principle set up very targeted, small clearinghouses with little capital to back trades.
One of the jobs of regulators actually making the rules to implement this legislation,
therefore, will be to do so in a way that really reduces the odds that the US treasury will
gain feel compelled to bail out speculators.
Basel III
Another key set of rules is the international agreement on minimum bank capital
ratios, agreed to in September 2010 at the Bank for International Settlements in Basel,
Switzerland, by a large number of national bank regulators. Minimum capital
requirements have become risk based and hence have quickly become complex. But the
agreement will raise these minima relative to what they have been[3].
Given the long eight-year phase-in, many informed observers would have preferred
to see capital ratios closer to 15 or 20 percent. Indeed, the hesitation by regulators to
raise capital requirements faster or more aggressively may re?ect the political
in?uence of the regulated ?rms on the process. Intellectually, there appears to be a
confounding of different concerns. As ?nance theory tells us, the lower the leverage,
the less risky will be the ?rm, other factors equal, and hence presumably the less costly
would be its capital. In its simplest form, this “Miller Modigliani” view of capital
arguably ignores the fact that it is costly and time consuming for potential equity
investors to learn what they need to know to allow an organization to signi?cantly
shift its capital structure toward more equity. Moreover, in the short run attempting to
raise a great deal of capital would con?ict with large bank management’s objectives to
pay dividends to shareholders and bonuses.
Nevertheless, the eight-year phase-in period allowed by the Basel III rules would
appear to accommodate a large increase in capital while making huge compensation
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packages possible. If in eight years a bank cannot raise that much capital from
investors, then that is likely be a clear market signal that it needs to shrink.
One measure of the usefulness of international minimumcapital requirements is how
satisfactory they are to the various national regulators. Setting too low an international
minimum would amount to relegating capital decisions back to each country. For
example, after Basel II, the USAimplemented a version with a higher core equity capital
ratio requirement for bank holding companies than was agreed internationally.
Although Basel III raised minimum equity requirements signi?cantly, some country
regulators such as the Swiss, are opting for signi?cantly higher capital minima.
Flash crash
On May 6, 2010 US equity trading was interrupted by problematic interactions of
automated trading and execution systems. This incident grabbed headlines because of
its demoralizing effects on already weak equity markets in the recessionary economy
(SEC and CFTC joint report, 2010). Early crashes related to computer guided trading or
systems problems have occurred episodically since the 1987 “market break”[4]. The
so-called “Flash crash” of 2010 was apparently precipitated by a clumsy large equity
order submission and by the extremely fast but uncoordinated actions of competing
execution systems. In part, the vulnerability of US equity trading markets to such an
occurrence was enhanced by the fragmentation of equity markets, a trend encouraged
by the US SEC, which had aggressively promoted market competition and innovation
without as much attention to its effects on market integrity under stress. While the
NYSE had developed automatic trading pauses designed to allow liquidity to be rebuilt
in the face of sudden price movements in individual shares, other markets had not been
required to do so. When a pause occurred on the NYSE, therefore, orders were rapidly
redirected to competing, unpaused trading platforms, some of which could not handle
the volume surges. As a result, nonsensical prices – from very high to nearly zero –
were generated, and many trades later had to be cancelled.
The SEC subsequently enacted rules that required trading of a security in all US
markets to pause when prices changed by 10 percent or more on the main listing market.
But these beg some important questions. One issue not addressed was the trading of
stocks outside the USA. While the need for liquidity tends to concentrate trading during
periods when markets are open, there is considerable overlap in the trading days of
Europe and North America. A halt of competing trading systems could create
opportunities for unregulated platforms and could disadvantage investors without
immediate access to ongoing trading. Therefore, for trading halts to be both effective
and fair, they must be coordinated not only within the USA but also internationally.
Because many stocks trade in multiple countries, broader international coordination of
rules in this type of case may become necessary.
A second issue left unaddressed is the de?nition of a stock’s main listed market.
Many stocks that are listed on a major stock exchange trade at least as actively on
competitor platforms. Many such competitors tailor fee structures and trading protocols
to attract particular groups of traders. As a result, the main stock exchange where a
company pays to list may not be where the most liquid trading in its shares can be found.
In short, it seems clear that the contention and episodic confusion in markets created
by multiple high-volume trading engines will continue to be a key policy issue going
forward. Hopefully, investors will be able to distinguish between technical
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coordination problems and more fundamental factors affecting market values. At the
heart of the problem is the need by individual investors to make decisions and trade
very rapidly, not because of the in?ow of information exogenous to the markets but
rather because of the need to be faster than competitors, even in the realm of
micro-millisecond trading. Also at the heart of the problem is the need for leadership
and informed oversight by regulators.
Conclusions
Globalization and technical change are combining to encourage large institutions and
more complex, faster trading technologies. The process is expanding to affect markets
all over the world. Mergers and alliances may create ever larger global ?nancial
institutions in the coming years. Indeed, it seems inevitable that, particularly as large
banks grow in emerging markets like Brazil, China, Russia, and other fast-expanding
economies, we will see a larger number of even bigger, more globalized banks and
investment banks than we now have. The issue of too big to fail and the problems
associated with the mismatch in size and capability between global banks and national
regulators appears likely to continue. In short, ?nancial markets during the next few
years will continue to grow more complex, interconnected and global, and with bigger
institutions. On top of all that, the technologies being brought to bear in trading place a
very high value on speedy – and hence computer-guided – actions, which means that
markets can become unstable in the blink of an eye. The question is whether
governments are up to the challenge of coordinating efforts to manage the risks,
challenges, and opportunities these organizations and technologies will present.
Notes
1. Dodd-Frank Wall Street Reform and Consumer Protection Act.
2. For example, one major international ?nancial news daily reported that, “Lloyd Blankfein,
chief executive of Goldman Sachs, has issued a clear warning that the bank could shift its
operations around the world if the regulatory crackdown becomes too tough in certain
jurisdictions” Financial Times, 30 September 2010, p. 1.
3. See Blinder (2010) for a brief summary and critique of the Basel III capital rules.
4. See “Brady Report” Presidential Task Force on Market Mechanisms (1988).
References
Acharya, V.V. and Richardson, M. (Eds) (2009), Restoring Financial Stability, How to Repair a
Failed System, NYU Stern/Wiley Finance, New York, NY.
Acharya, V.V., Cooley, T., Richardson, M.P. and Walter, I. (2010a), Regulating Wall St, The Dodd
Frank Act and the New Architecture of Global Finance, NYU Stern/Wiley Finance,
New York, NY.
Acharya, V.V., Pederson, L.H., Philippon, T. and Richardson, M. (2010b), “Measuring systemic
risk”, NYU Stern working paper, May.
Angel, J.J., Harris, L.E. and Spatt, C.S. (2010), Equity Trading in the 21st Century, Knight Capital
Group, Jersey City, NJ.
Blinder, A.S. (2010), “Two cheers for the new bank capital standards”, Wall Street Journal,
September 30, p. A25.
The (revised)
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“Brady Report” Presidential Task Force on Market Mechanisms (1988), Report of the
Presidential Task Force on Market Mechanisms, submitted to the President of
the United States, the Secretary of the Treasury, and the Chairman of the Federal
Reserve Board, US Government Printing Of?ce, Washington, DC.
Greene, E.F., Mcllwain, K.L. and Scott, J.T. (2010), “A closer look at ‘too big to fail’: national and
international approaches to addressing the risks of large, interconnected ?nancial
institutions”, Capital Markets Law Journal, Vol. 5 No. 2.
Janovic, B. and Menkveld, A.J. (2010), “Middlemen in limit-order markets”, working paper.
NYU Stern Volatility Vlab (2010), “NYU Stern systemic risk rankings”, NYU Stern working paper,
May, available at:http://vlab.stern.nyu.edu/analysis/RISK.USFIN-MR.MES
(The) Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission
(CFTC) (2010), “Findings regarding the markets events of May 6”, Report of the Staffs of
the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues,
US Commodity Futures Trading Commission and US Securities & Exchange Commission,
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Further reading
Lo, A.W. (2008), Hedge Funds: An Analytic Perspective, Princeton University Press, Princeton, NJ.
Corresponding author
Paul Bennett can be contacted at: [email protected]
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