Source: Thomson Reuters

Dec 23 2011 Michael Aitken recommended

Michael Aitken, chair of the Capital Markets Cooperative Research Centre in Sydney, suggests that evidence-based policy making could help regulators make better decisions about whether a market design change is good or bad for the financial services sector. He tells Thomson Reuters why the global financial markets are in a mess right now, and will remain so for a while.

Are dark pools good or bad for a marketplace? What about high-frequency trading — does that increase the quality of markets or not? What about circuit breakers, short sale bans, and other types of market design changes like market fragmentation and the newer phenomenon of market consolidations?

How do we go about getting objective answers to these perplexing questions about whether such changes are good or bad for financial markets?

Let's start by reviewing how we have been doing it. Some parties — regulators, market operators, financial intermediaries or traders — that want to change the way markets operate suggest to the securities regulators (and their bosses, the governments) that things might be done differently. For example, when Chi-X tried to enter the Australian market, it suggested that it would benefit the markets to have a new competing market there. The Singapore Exchange (SGX), in trying to take over the ASX, suggested that a merger of the two exchanges would be a good thing for both markets. While governments can become embroiled in such discussions, very often advice and recommendations came from the securities regulators.

As part of their consideration of such matters, regulators usually call for comments on the proposed changes, entreating respondents to provide evidence in support of their position. When those submissions are made public, a cursory glance suggests that evidence is in short supply. Unsurprisingly, therefore, comments from regulators on the submissions received end up referring to the number of submissions which support a particular position, rather than the weight of evidence that supports a position. In this system of evaluation, decision-makers are prone to accept the weight of numbers or the views of parties with high profiles or influence, bringing in the possibility of vested interests.

Authority versus evidence

The result of such a system of regulatory evaluation on security market design changes has resulted in a market that is focused primarily on authority rather than evidence. There are at least two obvious reasons for this. First, regulators have not supplied their framework for evaluation, in particular, how evidence might be brought to bear on their mandate to ensure their markets are fair and efficient. Second, the cost and time frames associated with the production of evidence are usually a lot higher and longer than the politically palatable comment periods. This leads to the inevitable conclusion that many decisions are being taken without sufficient evidence to justify them.

A specific case in point is the U.S. Securities and Exchange Commission's (SEC) decision to introduce circuit breakers following the Flash Crash event. Challenged by public's criticism on the effects of the Flash Crash on public confidence in the financial market, the SEC, without any obvious evidence, suggested that part of the reason for the problem was due to some markets staying open during the crisis while others, like the New York Stock Exchange, closed for short periods. Its logic — not evidence — suggested that the way to avoid such problems in the future was to force all markets to close. This has led to further debates about whether circuit breakers should be introduced.

At the risk of being somewhat controversial, I would like to know why the position of insisting that all markets stay open was not considered as a solution to the problem. Although evidence is in short supply on this issue, evidence that is currently available tends to suggest that a market that stays open ends up being less volatile than markets that are forced to close.

On a separate issue, the decision to ban short sales was arrived at despite a lack of evidence. The result showed that banning short sales is not a smart idea, which raised the question of why some regulators continue to ignore the available evidence. The only rational explanation for that is that they did not believe that the evidence was relevant to their market. While this explained some regulators' failure to gather the necessary evidence, it still does not explain why the regulators had not attempted to seek the evidence that was relevant.

Principle versus practice

One possible reason for the failure to gather and seek evidence is the cost and time it takes to provide evidence. To give you an idea, the Capital Markets Cooperative Research Centre recently estimated that it would cost it more than A$40 million to set up an infrastructure to facilitate evidence-based policy making. That would translate to an annual cost of about A$3m. It is, therefore, hardly surprising that few parties could afford such a cost. So how do we resolve this issue?

The simple answer lies in principle, and not in practice. It involves all parties sharing the cost of developing the necessary infrastructure. Such infrastructure must include data for every market in the world, software to analyse the data, and hardware (processing and storage) to manage it. On top of this, human resources who know how to use the data to design independent studies would be required to produce independent conclusions beyond the criticism of vested interests.

Beyond access to the infrastructure, one also needs a framework within which to orient the collection of evidence. Such a framework must start with the objective of the process — how can we objectively decide whether a given market design change, be it a change in technology, regulation, information mechanism, or instrument of participant, is good or bad for a marketplace?

Regulators' mandate

One way to address this issue is to understand the mandate of securities regulators. This is fairly straightforward as most regulators have a uniform mandate, namely, to ensure their market is fair and efficient. This means that to sign off on a market design change, regulators need to convince themselves that the change will enhance, and certainly not detract from, the efficiency and fairness of the marketplace.

The trouble is that, up until now, many regulators have depended on public consultation to assess whether a market design change is good or bad for the market. In my opinion, this is not good enough. Regulators have to be more forthcoming with a framework of evaluation, especially if they are hoping that respondents will provide the evidence they need. This framework needs to begin with their mandate and continue with them defining and operationalising fairness and efficiency.

Aside from the issue of having an infrastructure in place necessary to facilitate such evidence, it is only when regulators provide operational measures of fairness and efficiency can they hope to have respondents supply evidence to assist them in their decision-making.

As an example, if one was to define an efficient market as a market in which it is cheap to trade and in which one can be assured the price one trades at reflects all available information, the variables of interest in terms of measuring efficiency pre and post a change would be measures of transaction costs and price discovery. Similarly, if one were to describe fair markets as markets in which prohibited trading behaviours are minimised, that would require us to get an empirical handle on prohibited trading behaviours. The three classic ones being insider trading, market manipulation and broker-client conflict.

In principle, therefore, if I were to ask the question of whether dark pools are good or bad for markets I would have to measure how changes in the numbers of dark pools are associated with changes in efficiency (as measured by proxies for transaction costs and price discovery) and fairness (as measured by proxies for insider trading, market manipulation and broker-client conflict).

As a practical matter, while academics have been quite good at providing measures of transaction costs and more recently some have begun to address price discovery, few if any, have sought to develop operational measures of fairness. This would be critical before a regulator can begin to appreciate whether proposed market design changes are good or bad for a marketplace.

Deficiency in existing system of regulating

Little wonder, therefore, that we are in the current state of flux in the global financial markets. We do not even have a framework to address the basic regulatory mandate, let alone have any individual regulators investing in resources to allow such measures to be estimated. If we burrow a little further into the issues, we find that we don't even have the data to address these issues in the first place. How can we, for example, start to measure problems like front-running when brokers are not required to tell us whether they trade as a principal or as an agent.

Part of the problem is that we are being forced into making decisions on market design changes at such a pace that evidence becomes almost irrelevant. This clearly makes a mockery of so-called regulations requiring a cost versus benefit analysis of all regulatory changes. How can we judge the impact of any particular change if we are making dozens of changes at the same time? Research design 101 tells us that we can't, and the best we can do is to look at what the effects of combinations of changes are doing to efficiency and fairness. In my opinion this is not good enough, and indeed a recipe for disaster.

The deficiency in this way of regulating perhaps explains why we are seeing unexpected consequences. The fact that it takes six months to find out what happens in cases like the Flash Crash is also a stinging indictment of the systems currently in place in the U.S. to understand the effects of changes. This is one good reason to think twice about whether to follow the lead of the U.S. in its responses to market design changes.

Getting back to basics

We need to get back to basics and build a framework for the evaluation of market design changes, as well as the infrastructure to support the impact on efficiency and fairness of proposed market design changes. This framework is essential if parties that motivate market design changes are to be asked to supply evidence in support of their suggested design changes, which I think is an important development that is required to help fix the current systems.

Expecting regulators to do all the work is a recipe for delay if nothing else. Aside from a framework, we also need to commit the funding to create an infrastructure that is necessary and that will supply the type of evidence which I have referred to. This in turn will require cooperation across multiple stakeholders, which has, to date, been sadly lacking. It is no wonder that we are in the mess that we are right now, with the prospect that public confidence in the financial markets can only subside further.

Michael Aitken, is chief scientist at Sydney-based Capital Markets Cooperative Research Centre (CMCRC) and chair of Capital Market Technologies at the University of New South Wales, Australia. He is widely regarded as the most industry-centric academic associated with Australian capital markets.

As the founder and former CEO of SIRCA (www.sirca.org.au), he has used his industry affiliations to build and share infrastructure which now underwrites the research activities of 30 over universities across the Asia-Pacific. Through the SMARTS Group (www.smartsgroup.com), he has designed the world's first "off-the-shelf" surveillance software now in use at 40 national exchanges and regulators (including the London Stock Exchange, NYSE-Euronext, Nasdaq-OMX, HK Exchanges, the Swiss Exchange and the Australian Securities Exchange) and 150 brokers across 30 countries.

Aitken currently leads the research initiatives of the CMCRC which includes providing fully outsourced surveillance services to the securities industry, as well as outsourced surveillance technology to the health insurance and general insurance sectors.

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