Good morning and welcome to the Mondo Visione Exchange Forum 2011. I believe the conference is well timed, with an extremely important agenda - given that we are facing an especially critical and highly uncertain time for global markets. And if it is an uncertain time for the markets, then it is an uncertain time for every one of us in this room: we are all faced with the question of how to deal with the changes ahead, and how to turn risk into opportunity.
In times like this, we look at our legacy businesses and how to grow them. Perhaps we start to think about adjacencies to the current role our businesses play in the market structure. For example, If I am running an exchange, do I merge with another exchange in response to competition, do I presume that regulation of the OTC markets towards central clearing mean I should buy a clearing house, or do I generate new revenue from selling premium market data, or renting hosting and co-location space, or even start to sell technology?
Often these moves are difficult to pull off, obstacles arise that prevent progress, especially in the context of the waves of regulation that are emerging, the demands of investors of more for less, and the start-up competition can apparently take market share at will. We must all press on together in the face of real financial uncertainty, we have a shared responsibility to make markets work well.
Context always matters. So whilst we face an uncertain future, we can say that waves of regulation will indeed kick in – from Dodd-Frank, Mifid II, Basle 2 and 3 and EMIR. This will indeed lead to fundamental change: it certainly means an overhaul of OTC derivatives trading, the shift to centralized clearing and how margin is treated. The Regulations introduce a reporting obligation for OTC derivatives; a clearing obligation for eligible OTC derivatives; measures to reduce counterparty credit risk and operational risk for bilaterally cleared OTC derivatives; it sets common rules for central counterparties (CCPs) and for trade repositories; and defines rules on the establishment of interoperability between CCPs.
The Commission states that all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.
If you are an interdealer broker, with an electronic platform, perhaps your role as a true SEF has been formally validated. For banks, the capital requirements mean less profit, which means that apart from having to find ways to comply with inbound regulation and reporting, the single largest priority project for financial institutions today is to drive out expense to protect operating income. Expense reduction requires immediate investment in more streamlined processes, more business automation, and more effective systems to manage risk and provide adequate surveillance, and better connectivity to content, applications and sources of liquidity.
In the Exchange arena, we’ll likely see growing interoperability leading to liquidity consolidation, either through mergers (although those are proving difficult to pull off) or consolidation through alliances – virtual connections between partnering venues – all of which requires even more efficient connectivity and transparency. In our own business, our Elektron initiative is seeing a significant influx of customers including prime brokers and venues seeking to efficiently cross connect to Liquidity and ever faster, deeper and relevant content.
Perhaps if we stand back from all of these impacts, what does all this enforced change mean for actual trading liquidity?
This brings me just three words to consider.
Connectivity. Transparency. Liquidity.
We use these words all the time, perhaps it would be interesting to stop to think what we mean by them.
Connectivity, transparency, liquidity: we probably think they are all good things.
We may also think they are absolutes too. We must talk about ‘degrees of connectivity’ and ‘degrees of transparency’. Perhaps there are limitations to liquidity? Does greater connectivity and transparency necessarily lead to greater liquidity? For without solid liquidity all the mechanisms, regulations and facilities are for naught.
With greater interconnectivity and speed in global financial markets, as with any complex system, we may in fact get more randomness and uncertainty. And when things become more fragile and uncertain, we are using words that investors or the markets don’t like.
With ever more sophisticated trading strategies involving many more trading firms, multiple venues and intertwined asset classes, we are seeing constant growth in demand for connectivity. And pools in the BRICs countries and Asia begin to cross trade, with new alliances such as that between the Asian exchanges, BM&F Bovespa of Brazil, the National Stock Exchange of India, the Bombay Stock Exchange, Johannesburg Stock Exchange and Micex and RTS in Russia and so on, creating aggregate substance from smaller markets, and attracting order-flow across borders.
From an investor perspective, it may become more and more difficult to understand what is going on. How do they keep track of the real liquidity and the true cost of execution?
Now let me say right away that for some this complexity is a good thing. There are plenty of hedge funds and investment banks that make a living from taking a different view of on the maturity of Alpha from others, they analyze complex information to gain a better understanding of what is going on.
They can arbitrage between their understanding and the market. For them, complexity can be a good thing. They can work the market systems – both exchange based and OTC – without showing their hand – perhaps best illustrated by the growing use of ‘algo scaling’, artificial intelligence and machine-driven strategy plays.
But financial markets, particularly outside the exchange traded world and at the boundaries between OTC markets, are increasingly complex and that creates special problems of transparency.
What we have is a case of ‘information asymmetry’. Some people know, others don’t.
As Michael Spence, puts it
".......as the complexity of the system increases, gaps and asymmetries in terms of information, knowledge, and expertise are multiplying.
Such asymmetries impair market performance in a variety of ways, and conflicts of interest are particularly dangerous in such an environment because they create an incentive to exploit precisely these advantages."
In other words, information asymmetry is a good thing if you know and no-one else does, a bad thing if everyone is flying blind – as arguably some participants are right now.
This raises important questions about level playing fields.
True, connectivity and transparency can begin to break this down, but in fact this asymmetry is part of the diversity, and so the undoubted strength of markets. It is not all a bad thing. OTC markets function because they are flexible and can create novelty. They can adapt.
If everyone had the same information and traded in the same way, what sort of markets would we have? We have to have levels of differentiation for markets to flourish as clearly too much certainty would be as bad as too much uncertainty.
Ultimately, only more and better information and machine intelligence can help keep market access level and satisfy the public, politicians and regulators, in part because only machines can keep pace with market dynamics and flows.
So the background to all this is the essential relationship between information transparency and liquidity. As a Company, Thomson Reuters and others strive to aggregate content and connectivity to create an open market fabric in which to trade with confidence.
The grand challenge to anyone concerned with markets is how to translate connectivity and transparency into liquidity, and since liquidity has a lot to do with solvency, translate it into greater economic and financial well-being, if not system-wide stability.
That seems to me to be the goal of political leaders, regulators, exchanges and just about everyone involved in the financial markets.
So as I see it, delivering more and better information is crucial if we are to make the balance between connectivity, transparency and improvements in liquidity, because it opens up new possibilities.
One way of looking at the importance of information is to relate it to uncertainty and risk.
If we follow Knight’s view of uncertainty, the simple formula is that more information, less uncertainty. Yet he also talks about what we now tend to call ‘unknown unknowns’ or ‘Black Swans’
But however we see want to define it, this not about passive information. Given the increasing complexity and volatility of the markets, we are in a race to produce analytics that make sense of what is going on, mapping emerging new relationships across and between individual markets, aggregating and integrating content in new ways and providing new models to create market intelligence.
But information is not passive in another way. There is an important distinction between pre-trade and post-trade.
We have come a long way in reporting what has happened, but we have a long way to go on what might happen.
So why do I call this a grand challenge?
Well, let us think about it.
At any moment, buyers and sellers have orders looking for prices and execution. Yet those orders may be complex in multiple asset classes, sequenced and dependent on say a chain of execution ‘events’. They may depend on the intentions and feedback of other buyers and sellers in multiple systems and they might be routed to both OTC and exchange markets.
Our buyers and sellers are of course connected to our screens, messaging, trade management and execution systems across any number of venues.
We are providing this sort of connectivity already. But we see now that the market is growing for what some observers are calling ‘multi-asset trading integration’.
There are many different ways of seeing this, but one way or another, the ability to “see” portfolios across different asset classes is likely to become ever more important.
This is why we are rapidly providing more and more connections between investors, markets and a whole new group of participants around the world. Peer to peer connections are on the horizon, as well as a growing number of large-scale, highly networked hubs including exchanges, exchange alliances, MTFs, brokers and clearing houses. All this increases the depth of information and so the potential depth and potential for increased liquidity.
But there is another step.
While everyone may become connected, many can only ever “see” a fraction of the possible - let’s say latent - trades behind the picture. They have a trading strategy, and the right liquidity is out there, we just need to find the best trade and the right counterparty. Increasingly complex trades must be executed in rapid sequence without legging risk, where one failed trade might break the sequence. So perhaps our next frontier is the true optimization of liquidity.
I believe, as an industry, and for all of us in this room, we have a long opportunity for innovation and collaboration ahead of us. The grand challenge is not only to deliver more and better information to reduce uncertainty, but how to generate new forms of efficient and market building liquidity for the benefit of all.
This Mondo Visione conference gives a platform for you to debate – more eloquently than me, I’m sure – the inbound changes facing market structure and in a more regulated, more debt constrained world, how we can all respond effectively. These responses will help us come together as an industry led union that will help shape and improve the future of the world's financial markets. I for one believe this is an exciting prospect.