You can’t accuse U.S. Treasury Secretary Henry M Paulson, Jr., of ignoring expert advice. His recently-announced “capital markets competitiveness action plan” (see “Paulson’s Plan,” below) is a direct response to expert criticism of the way the United States regulates its capital markets, and a response it’s clear he’s been wanting to make for a long time.
After concluding that the U.S. is woefully unable to attract capital in this day of universal transparency and borderless trading, Paulson officially floated his capital markets comeback plan in late June, although, truth be told, it’s more of a “list of things to talk about” than it is something resembling the European Union’s Financial Services Action Plan (FSAP), which was cobbled together by the European Union Commission throughout the 1990s and has been implemented step-by-step through the past seven years.
The FSAP, which has a major milestone coming up in November, began much as Paulson’s plan has, with the acknowledgement of a problem, and a high-powered academic leading a task force of wise men coming up with solutions. In Europe, the problem was a fractured capital market, and the academic was Alexander Lamfalussy, a respected professor and central banker who served as chairman of the Committee of Wise Men set up by European Finance Ministers to propose reform of
Europe’s fragmented securities regulations.
Here in the U.S. the problem is a hodgepodge of outdated regulatory mechanisms and practices, and the high-powered academic is Harvard Professor Hal Scott. Last year, he formed the Committee on Capital Markets Regulation to evaluate the competitiveness of U.S. capital markets, and since then the committee’s interim report (available for download at capmktsreg.org/research.html) has become a cornerstone of Paulson’s plan.
THINGS TO TALK ABOUT
“In the late 1990s, the U.S. exchange-listed capital markets were attracting 48% of all global IPOs,” the report states. “Since then, the United States has seen its market share of global IPOs drop to 6% in 2005 and is estimated to be only 8% [in] 2006.”
Contrast that to London: “After more than a decade of declining market share, in the past three years, London has increased its share of the global IPO market from 5% to almost 25%,” the report states. “Furthermore, London has begun to attract a greater share of IPOs from U.S. domiciled companies.”
The upshot: the U.S. Initial Public Offering (IPO) market isn’t holding its own against foreign and domestic competitors, and the report identified four factors leading to this loss of competitiveness: foreign markets have simply gotten better and more transparent; foreign markets have become more liquid, reducing the incentive for non-U.S. companies to list in the United States; technological advances have created a global marketplace allowing Americans to invest more easily in non-U.S. companies (see “Taking stock of opportunities abroad,” below); and differences in regulation.
“The first three are beyond our control,” says Scott, “So we focused on what we can do something about.”
The report also reminds us that London was the world’s financial center before World War II, and that New York had best get used to competing. “For much of the 60 years since the end of World War II, firms raising capital did not so much choose to come to the United States, they came naturally,” it states.
What’s more, while the report repeatedly refers to superior regulatory regimes around the world, it’s clear they are referring to one regime that stands above all others: the United Kingdom’s Financial Services Authority (FSA). “It is worth noting that London, for many years lacking the dominant position in worldwide capital or investment opportunities, which arguably it once held, has been able to retain its position as a leading financial center by choice, not necessity,” the report states.
But U.S. exchanges aren’t just losing out to foreign competitors. The report also charts the flood of money into private equity investments, which don’t have to deal with the tough disclosure requirements, hefty liability provisions, and all those costs of complying with Section 404 of the Sarbanes-Oxley Act (SOX 404) that publicly-listed entities do (see “Going private,” below).
Private equity has become the vehicle of choice for non-U.S. entities looking to raise funds in the United States, and the percentage of domestic public takeovers that have been done through private equity rose to above 40% in 2006 — depriving smaller investors of an opportunity to participate in capital markets (see “Following the money,” below). The report then goes on to flay the U.S. system for providing less protection to shareholders than the Brits do while creating more regulatory headaches.
PRINCIPLES AND RULES
A cornerstone of Paulson’s plan is to emphasize principles-based, risk-focused regulation over dot-the-I and cross-the-T style regulation. This has often been referred to in the press as “light touch” vs. “heavy hand” — terms that make British regulatory boss Callum McCarthy bristle.
As head of the FSA, McCarthy has often stated that “risk-based” regulation means focusing regulatory resources on people, places and markets based on how much risk they present to investors or to the financial system, and not throwing out the rule book.
In fact, in a February speech, McCarthy pointed out that the FSA backs up the 11 principles of its regulatory approach with an 8,500-page rule book. He says the key isn’t fewer rules, but rather ensuring that the rules in place don’t override guiding principles, a concept known to most of us as “common sense,” but one often lacking in the realm of regulation.
Scott says it’s not a question of black and white, but of degree. “I don’t know that anybody has really counted our rules, but I’m sure it’s a factor of at least 10 or 100 of what Callum has,” he laughs.
But why so many rules state-side? Scott pins the blame on the American practice of handling shareholder disputes via class action lawsuits rather than through official enforcement as in the U.K.
CLASS ACTION MORASS
Such suits theoretically make it possible for small shareholders to battle the larger ones and protect themselves from mismanagement or misrepresentation, but in reality are often initiated by law firms keen on making mountains out of molehills and play one group of shareholders against another. The result is a perception, based on experience, that if a company’s share price drops, a flurry of lawsuits will follow, usually to be settled out of court.
“Basically, we don’t see how that does anything for shareholders,” says Scott. “You end up with a payment from one group of shareholders to another, with lawyers in the middle grabbing 25%.”
Ironically, such suits are the envy of shareholder activists in Germany, but Scott says they are the key driver behind the tedious rules hobbling the U.S. IPO markets. “Because these disputes in the U.S. end up in litigation, everybody is looking for more rules to make sure they’re doing the right thing,” he says. “You end up with the opposite of a principles-based approach to regulation.”
But what to do? “You could pass a law that says ‘no’ to class actions, but that’s not going to happen,” he says. “We decided to focus on what’s politically possible, and we suggest that since shareholders are the ones most impacted, they should be able to amend a corporate charter so that instead of class-action, disputes are handled via arbitration.”
Indeed, arbitration agreements work in the derivatives industry and ensure that disputes are handled by competent parties who understand the issues and generally aren’t biased to either side.
“In the U.K., the FSA has the exclusive ability to interpret their principles, not the courts,” says Scott. “And, when these things go to court over there, the U.K. also has a sort of ‘winner recovers costs approach,’ meaning if you sue and lose, you have to pay the costs. But that’s not going to happen here, either.”
PAULSON’S PROGRESS
Litigation is hardly the only problem cited in the report, and several other issues have already been dealt with. Chief among these: a rule dating back to the 1930s made it nearly impossible for U.S.-listed companies to delist once they floated. “That’s been corrected,” says Scott. “It’s an improvement because, if it’s easier for them to delist, you can expect more of them to list in the first place.”
But challenges remain, not least everyone’s favorite whipping boy, SOX 404. Scott says compliance is still too costly for smaller companies.
But differences in rules are just one of the factors impacting competitiveness, and the European Union is forging ahead with a key provision of its FASP, the Markets in Financial Instruments Directive (MiFID).
EUROPE’S NEXT STEP
MiFID is just three months away from coming into effect, and the governments of the 27 E.U. member states plus Norway, Lichtenstein and Iceland are scrambling to get their financial services sectors up to par.
The directive’s goal is to harmonize regulated markets and protect consumers across Europe while also setting the stage for greater integration of global markets.
Like all E.U. directives, it outlines broad principles agreed upon by legislators from across the E.U., and these principles are to be “transposed” into national law by individual member states.
The deadline for transposition was Jan. 1, 2007 and the deadline for implementation of these transposed laws across the E.U. is Nov.1, 2007. In late June, the E.U. Commission warned that member states that fail to meet the November deadline will have to defend themselves before the European Court of Justice.
The number of member states on the warning list was an astonishing 24, or 80% of the total obligated to comply with MiFID. Those numbers seem especially dire when you stop to consider that Norway, Lichtenstein and Iceland are members of the European Economic Area (EEA) but not of the E.U., and thus aren’t answerable to Brussels. In fact, only three E.U. member states — Britain, Ireland and Romania — met the January deadline, which was supposed to give banks, brokers and other investment firms nine months to prepare for implementation.
However, the bulk of those nations that missed the deadline are smaller states with relatively undeveloped capital markets, while regulators in larger nations like Germany have kept their financial services providers in the loop from the start and say the close cooperation between private and public entities eliminates the need for a nine-month lead.
THE KEY ELEMENTS
For the derivatives sector, the early impact of MiFID will be felt on the retail side, as laws governing the sale of retail products of all stripes come into effect. This includes commodity futures, which are being regulated across Europe for the first time ever, although most bona fide hedgers are exempt from regulation.
The most controversial provisions, however, are those dealing with best execution, which require that customers in all parts of the E.U. EEA be given equal access to the best possible price on all traded products on all platforms in all jurisdictions. This mandates several major changes to the industry, and directly impacts equities trading from day one. It will gradually come to include derivatives, and is a key driver in the changes sweeping European exchanges.
INTERNALIZATION
Like Regulation, National Market System (Reg NMS) in the United States, MiFID makes it easier for listed shares to be traded off-exchange, a practice so far illegal in France, Italy, Spain and Belgium, all of which have so-called “concentration” rules mandating that trades in listed shares only be executed on a registered exchange. Unlike Reg NMS, however, MiFID theoretically applies to exchange-traded derivatives too, albeit not from the get-go.
By outlawing concentration rules and mandating best execution, MiFID theoretically gives a boost both to Alternative Trading Systems (ATSs) across the continent and to broker-dealers, who can save a fortune on transaction costs by “internalizing” trades on their own in-house Multilateral Trading Facilities (MTFs).
These MTFs, however, are restricted to eligible counterparties and subject to new pre-trade and post-trade transparency rules, with an exemption granted to block trades so that market-makers can have the leeway to negotiate specific deals, which they claim promotes smooth markets.
But not everyone agrees. “Everyone should have to operate on equal footing,” says Richard Olsen, co-founder of the Oanda trading platform. “Instead, they are creating a multi-tiered club, where end users are being shunted from one club room to the other, with best execution being rather vaguely defined.”
On the equities front, a report entitled Alternative Trading Systems (ATS) in European Equities published by Celent credited the best-execution provisions with driving down transaction costs and forcing equities exchanges to diversify into derivatives even before MiFID comes into force.
That’s bad news for the much-anticipated ATS revolution, but has been a boon to connectivity providers like Sweden’s NeoNet.
“The European landscape has been one-dimensional in terms of central order book model,” says NeoNet Senior Vice President Greg Treacy. “We look to benefit because we have the technology and the duty as an agency broker to route to wherever we need to in order to satisfy the best execution requirements of MiFID.”
A larger question is whether internalization will add or detract from liquidity. “Reg NMS started the best execution phenomenon in the U.S., and there’s mixed sentiment on how productive or counterproductive it has been, with so many participants and so many levels of fragmentation,” says Treacy. “In fact, many European clients are happy with the central order book model, despite the lack of competition, because they get concentrated liquidity.”
THE ANTI-CLIMAX
London-based Mondo Visione warns that MiFID might even disrupt continental trading. They recently published a tome entitled World Exchanges: Global Industry Outlook and Investment Analysis, which includes a detailed analysis of MiFID and its potential impact on exchanges.
Mondo Visione CEO Herbie Skeet, who edited the report, cites three risks flowing from MiFID’s best execution provisions: First, he says, drawing orders from existing exchange central order books could make prices quoted on exchanges less informative.
Second, “It may weaken central markets by reducing the incentive for competing brokers to price aggressively.”
Third, “Broker-dealers may face a conflict of interest. For example, they could time the execution of their retail clients’ orders to fit their own trading interests or those of a larger customer.”
On top of that, he fears cross-border retail trading won’t materialize as hoped unless the E.U. implements clear procedures for dealing with cross-border disputes and resolves the ongoing issues involving expensive cross-border clearing and settlement.
While in the States, Europe’s, or more precisely London’s, principal based approach to market regulation seems to be a panacea and elicits fear of being left behind, Europe is working through its own market structure issues. In the end there seems to be a growing realization that we are in a global market and individual market structures must adapt to it.
