The paper calls on the EU to maintain a tough stance on:
- high frequency trading, which damages traditional investors’ trust in markets, drains useful liquidity and increases the potential for market abuse;
- commodity derivatives speculation, which inflates commodity prices and degrades the futures markets for genuine hedgers;
- over-the-counter and dark trading, whose growth (partly as a refuge from HFT) damages price formation and market fairness;
- andinvestor and employee protection, which are undermined by inducements and adverse sales incentives.
It also calls for the EU to drop the proposed “OTF” trading venue category, which risks opening the door to regulatory arbitrage.
The paper’s author, Benoît Lallemand, said:
Financial markets play an essential role in supporting our economy. We welcome the MiFID 2 proposals for increased transparency and supervisory powers and for measures to discourage harmful trading practices. After the European Parliament’s current work, the spotlight will shift to the Council to take these proposals forward.
In a series of detailed case studies, “Investing not betting” exposes the practices behind high frequency trading, commodity index investing and dark trading, to explain how these practices are detrimental to the functioning of financial markets and their contribution to the real economy. It debunks a number of commonly held beliefs, arguing that:
(i) trading venue competition has not benefitted the economy,
(ii) HFT does not create liquidity,
(iii) commodity index funds are not investment products and
(iv) disclosure of sales incentives is not enough to resolve conflicts of interest.
It presents recent academic research linking commodity speculation to food riots and social unrest around the world, demonstrating the impact of HFT on commodity derivatives and equity market correlations, looking at the history of stock exchange demutualization, and at the effectiveness of financial markets over time.
Thierry Philipponnat, Secretary General of Finance Watch, said:
We forgot that the primary objective of financial markets is to channel savings and capital to the most promising economic developments. Deregulation of equity, bonds and derivatives markets has undermined this goal and we now face an urgent need to re-direct capital from short-term, speculative use to long-term investment in the productive economy. For some participants, this shift is going to hurt but it is a challenge society needs to face.
The 10 key points from the report are summarized below.
Benoît and Thierry are now available for press interviews. To arrange an interview please contact firstname.lastname@example.org +44 (0) 7703 219 222
MiFID refers to the EU’s legislative proposals for a new directive and regulation on Europe’s markets for financial instruments. More information can be found on the European Commission’s MiFID page at: http://ec.europa.eu/internal_market/securities/isd/mifid_en.htm
MiFID timeline (indicative, as of April 2012):
- October 2011 – MiFID 2 proposal published by the European Commission
- April 2012 – European Parliament rapporteur Markus Ferber (EPP, Germany) presents draft report
- 10 May 2012 – Deadline for MEPs in the Economic and Monetary Affairs Committee to table amendments
Negotiations between the Parliament, Council and Commission will start once the Parliament (MEPs) and Council (Finance Ministers) have adopted their respective compromise positions. MEPs in the Economic and Monetary Affairs Committee will vote to confirm their position, and Finance Ministers will adopt a ‘General Approach’ as a starting position. For both institutions, the earliest date for this to happen is in July 2012.
Negotiations between the institutions will therefore most likely start after the summer break, in September 2012, and could last until the end of the year. The agreement between the institutions must then be confirmed by a Parliament plenary vote and ECOFIN Finance Ministers. The Parliament’s earliest possible date for a plenary vote is 10 September 2012, although a plenary vote in November or December is more probable.
The procedure described above assumes that there is sufficient common ground between Parliament and Council to achieve a “first reading agreement”. This procedure has become common in financial services legislation to speed up decision-making. However, the Parliament also has the option to vote its position in plenary without prior agreement with the Council. Finance Ministers would then formally adopt a negative opinion on Parliament’s proposal (‘Common Position’) and trigger a second reading of the legislative proposal. In this scenario Parliament could vote early in the autumn of 2012 and the Council would reject Parliament’s proposal shortly afterwards. Parliament’s Economic and Monetary Affairs Committee would then start its second round of deliberations on the Council text and propose amendments to the contested parts of the text. This procedure has a time limit of four months, which could actually lead to a quicker result than an extended first reading.
Key points from “Investing not Betting”
1. Serving the real economy and society as a whole. This title should be more than a punchline: a clear lesson from the crisis is that financial markets lost sight of their very purpose. This failure has undermined the core objective of MiFID, which was to support economic growth by supplementing bank lending with more market-based financing.
2. Financial markets will not fulfill their core function without regulation. It is only natural for market participants to develop their most profitable activities, regardless of the bigger picture. Markets need institutional and regulatory incentives to ensure that, as well as profits, they deliver the social and economic benefits of cost-effective resource allocation and financial stability.
3. The utility role of market structures has suffered under the drive for venue competition. Ever-increasing competition between trading venues has shown its limitations. Trading venues, clearing houses and central securities depositories have a public utility role to play, fostering transparent and fair trading, limiting counterparty and systemic risk, securing transactions and acting as a ‘securities notary’. This role should not be overshadowed by the sole objective of making profits, or internalized as an ancillary service by large investment firms.
4. Investing is fundamentally different from betting. Investors share the fate of issuers: they focus on fundamental value and stewardship, and they win or lose with the success of the underlying project. Speculators focus on price movements – in any direction – and the behavior of other speculators. A market dominated by speculation quickly becomes divorced from economic activity, burdening society with a poor allocation of resources.
5. Liquidity should not be confused with volume. Liquidity is the ability for a market participant to buy and sell with minimum market impact. Very differently, volume is a measure of the number and monetary value of transactions effectively realised regardless of the price impact of those transactions. Liquidity and volume are not only different concepts but they also often contradict each other as, for instance, when volume generated by aggressive speculative behaviour takes away liquidity from other market participants.
6. High-Frequency trading damages liquidity. HFT creates volume but not liquidity. It is either built on trend-following strategies that generate volume but take away liquidity, as evidenced by their market impact, or on so-called ‘liquidity-making’ strategies that collect liquidity rebates but in reality provide no liquidity, because the limited depth and milliseconds duration of their quotes denies proper investors the chance to transact for significant amounts when needed. HFT threatens market fairness, order and integrity.
7. Excessive commodity speculation raises prices artificially and damages the market for real buyers and sellers. Financial products linked to commodities are proven to raise commodity prices to artificially high levels, harming consumers everywhere and the poorest most of all. They also hamper the normal functioning of commodity derivative markets so that natural buyers and sellers of commodities cannot hedge their exposures as effectively.
8. Dark trading below ‘large-in-size’ is detrimental to fairness and price formation. The rise of dark and OTC trading reflects a growing lack of confidence in markets, caused largely by a surge in HFT and insufficiently restrictive waivers on transparency rules. It has had a negative impact on the economic meaningfulness of market prices and allowed large investment firms to profit at the expense at other market users. Private trading clubs that are open only to certain players should be banned.
9. Most derivatives can be traded on MiFID 1’s existing trading venue categories. The G20 commitment to clear and trade OTC derivatives can already be met through the existing venue categories of ‘Regulated Market’ and ‘Multilateral Trading Facility’. The proposal for a new and less regulated category, ‘Organised Trading Facility’, is unnecessary and runs the risk of regulatory arbitrage.
10. Protection of investors and employees go hand-in-hand. Inducements paid to distributors of financial products create conflicts of interest that endanger the quality of advice given to retail investors. In similar fashion, sales targets can incentivize the sale of inappropriate instruments to customers and prevent employees from properly fulfilling their advisory role.