By Rob Hegarty, Global Head of Market Structure, Thomson Reuters

As with so many things in our global financial markets today, the devil is in the detail, or perhaps in the definition. The growing complexity and volatility of today’s financial services industry does not come free of twists and turns. Yet, despite the changing times and unpredictability of the markets, we must avoid falling into the trap of distancing ourselves too much from the original meanings and nuances of particular concepts or notions that make our industry what it is today. Using terminology loosely may lead to unintended misconceptions or misunderstandings, and in turn, to mismatched conclusions.  It seems, for example, that the industry has started to use the terms “regulation” and “market structure” interchangeably when clearly regulation is but one element that makes up market structure.

21 Feb 2012Thomson Reuters

Market structure is a concept that has increasingly been subject to such potential confusion. And this may not be surprising because, as a term, ‘market structure’ is used, industry-wide, and the boundaries of its meaning are blurred. Its connotations seem ever changing. Just three years ago, a differentiation between trade and post trade market structure would not have been viewed as such. Today it’s the norm; even the requirement.

Traditionally, market structure – in any industry – describes the state of a market with respect to its competition. As a concept, it touches upon and is influenced by a wide range of market characteristics. In global financial markets major factors that continue to shape the market include: technology advances and innovation, marketplace and post-trade fragmentation, cost containment, fluctuating trading volumes and volatility, the need to deliver and enhance transparency industry-wide, and shifting global economic influences and regulation.

The way in which market structure, as a term, has been perceived through the years has varied widely and considering its definition is subject to market events, changes of focus in the industry and economic downturns, this should come as no surprise.

To a large extent, the 2008 financial crisis transformed the way in which market structure was viewed and addressed by the industry. The financial crisis set the stage for what was going to become, and still is today, the platform for a regulatory overhaul as has not been seen in financial services before. Post the days of the Lehman collapse, discussions around regulation inevitably gained ground and the need for greater market oversight took the industry by storm. In doing so, regulation also seemed to take over the vision of market structure itself, its connotations and even its definition.  This is true to the extent that in today’s markets, and in the eyes of many, market structure has lost its traditional connotations and become a synonym for one of the most imperative and vital ongoing developments and discussions in the industry; regulation.

Far from being a synonym of market structure, as some market participants seem to be addressing it at the moment, regulation remains one of the most important drivers shaping market structure at the moment. The shift has been major. Prior to the days of September 2008, few would have mentioned regulation – let alone legislation – as a main driver behind market structure change. At the time, other factors such as cost reduction, risk mitigation and technology innovation would have been mentioned instead. Today – only four years later – we find ourselves exploring how regulation appears to have taken over how market structure is considered by the industry as a whole.

Regulation, Uncertainty & Change

Such a wide disparity is understandable. Regulation has become the biggest influencing factor in changes to market structure by a wide margin and looking at the current regulatory environment, and what is yet to come, there is no doubt as to why this is. Both Dodd-Frank in the US and the European Market Infrastructure Regulation (EMIR) in Europe promise to raise the regulatory bar in ways we haven’t seen before. By demanding exchange trading and central clearing for OTC derivatives, new regulation of hedge funds, new definitions of accredited investors, and reporting on compensation by large companies, Dodd Frank promises to have a vast impact on financial services in the US and beyond (note the increasing heat being brought upon by “extraterritoriality”). And with EMIR, the requirement for clearing and reporting of OTC derivatives, as well as setting out operational requirements for central counterparties (CCPs) also promises to drastically alter the European regulatory community.

Last October, the European Commission’s release of the Markets in Financial Instruments Directive II (MiFID II) proposals further highlighted the challenge industry faces, as well as the changing times and the push for transparency. When Mifid came into force, in November 2007, the regulatory arena was very different.  The revised directive evolved from a set of rules to protect retail investors to a set of proposals to increase transparency at fragmented European trading venues.

MiFID II is also digging deep to examine what high frequency trading (HFT) is all about in Europe, while the Commodity Futures Trading Commission (CFTC) attempts to define and dig deep on HFT in the US. In a push to enhance further transparency, in an idea first articulated by the US Securities and Exchange Commission post the flash crash, automated traders will be required under Mifid II to post bids and offers – to make markets – throughout the day regardless of market conditions. At the time, the International Organization of Securities Commissions (IOSCO) identified the use of HFT as a contributing factor to the crash. And with CFTC set to create a subcommittee devoted to HFT and its effects on the market the regulatory focus on this space is only bound to grow further.

Despite the ongoing regulatory discussions, however, we must not forget the level of uncertainty that lies behind such talks and how uncertainty may affect future market structure. The politicisation of regulatory debates has become, as was expected, inevitable as the race for the White House intensifies. What was once a foreseeable shift from legislation to campaigning in the US is already becoming a reality. As the election campaigns heat up, distraction from the implementation of outstanding rules will rule the day, for the remainder of this year, anyway.

Regulatory debates are bound to take a back seat, leading to a visible slowdown in rule implementation; however this temporary period will not represent a halt to the regulatory push. The end of the race for the White House, come January 2013, will have a direct impact on the legislation that is finally passed.

Such uncertainty is also bound to translate itself in Europe where economic conditions are poised to accelerate regulation and accentuate market structure fragmentation.  While the US braces itself for the presidential election, Europe finds itself having to tackle a crisis that has not only gripped its financial institutions but also its governments. And this may only have a negative impact in years to comeas trading firms and investors look to identify stronger countries and position their portfolios and operations accordingly. The European financial crisis is perhaps one of the best examples of regulation not being a primary driver of market structure change.

In the yearsfollowing the 2008 financial crisis, there is no doubt that the industry has seen a new era of regulatory reform unravel, bringing regulation to the fore as the primary driver of market structure change. The vision around the type of supervision necessary in today’s markets has changed, complexity has grown and firms are already experiencing and getting ready for regulatory change and what is yet to come.  However, it is of critical importance that we do not forget the other significant drivers of market structure change beyond regulation. Technological innovation, fragmentation of markets, and fluctuating volumes are but a few of the drivers of market structure that should not be lost in this relatively recent wave of regulatory change occurring. So, let’s not confuse market structure with regulation.  They each deserve their own place in the future of global financial markets.