Exchanges are coming close to the edge
Comment of the Day

June 08 2010

Commentary by David Fuller

Exchanges are coming close to the edge

My thanks to a subscriber for this apt article by Michael Gordon for the Financial Times. Here is a brief section
Equity market gyrations of recent weeks have become a hot topic for both regulators and participants. With some questioning whether the markets are currently fit for purpose it maybe useful to step back and remind ourselves of the primary purpose of the equity market.

Equity is the preferred vehicle for long tem company financing. Its lack of a term distinguishes it from debt, which is finite and so better suited to shorter term financing needs. Public equity markets exist so that owners can realise their investments and new owners can be found. In theory, equity owners are medium to long term in nature, thus matching the nature of equity itself. To better enable or facilitate the trade in equity on a day-to-day basis, firms with no genuine interest in the long-term success of the companies whose equity they trade are allowed in the market. They seek to profit from doing so, as a reward for the capital they allocate. That is entirely reasonable.

But the ability of the equity exchanges to facilitate these other players more effectively has led to the activity on the equity markets to be dominated by them. Aided by advances in technology, their dominance is starting to cause long-term users to doubt whether markets are becoming less effective.

One example is the growth of high frequency trading. In the US, it has left the market often hostage to the consequences of behaviours that have little to do with the underlying long, medium or short term economic realities of stocks. This is so because as much as 70 per cent of the share trading volume on the US exchanges is now high frequency. The exchanges are happy because a new revenue line has emerged.

However, this trend threatens to take the exchanges away from their original purpose. And when that happens, the markets risk ceasing to provide the core function for which they are designed. As with prog rock, the real fans are being sidelined.

David Fuller's view I strongly agree with this article by Michael Gordon who is the chief investment officer for equities at BNP Paribas Asset Management.

I am unrepentant in my earlier view that high-frequency trading has become another weapon of mass destruction. Fortunately, regulators are paying more attention following the temporary meltdown on 6th May.

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