The State of the Markets
Technology is bringing about vast changes in worldwide financial markets, generating improvements in efficiency, speed and economies of scale. But as technological change continues to occur, attention must also be paid to changes in the role that regulation plays, said industry leaders in a panel on "Technology and the Future of the Financial Markets."
Worldwide financial markets are in a period of extraordinary change, as they gear up for more and more volume, work out an assortment of mergers and consolidations, contemplate the reality of 24-hour global trading, adopt new advances in security, and continue to consider the role of regulation. High on every agenda as well, of course, is the use and impact of technology, and that was the focus of a Global Alumni Conference session hosted by HBS professor Richard Nolan.
Titled "Technology and the Future of the Financial Markets," the panel featured three industry leaders from Europe and the United States: Dr. Werner G. Seifert, chairman of Deutsche Borse (the German Stock Exchange) and an architect of the planned merger between his Frankfurt-based organization and the London Stock Exchange; James L. Cochrane, senior vice president for strategy and planning at the New York Stock Exchange (NYSE); and Robert C. Gasser, managing director and head of U.S. equities at J. P. Morgan & Co.
Financial exchanges today, Seifert began, must have the business systems of a technology company, with the requisite speed and economies of scale, to create and operate efficient markets and help provide a variety of services for a wide range of customers. "There is a direct relationship," he said, "between technological development and the liquidity of markets. We are all involved in generating more transactions, creating additional markets, and inventing new indices." Technology is a means to that end.
Technology, Efficiency and an Aging Population
From a macroeconomic perspective, Seifert pointed out, technologically advanced and efficient capital markets will play a key role as countries face a major demographic crisis—providing retirement and medical benefits to the next generation of elderly, whose burgeoning numbers will dwarf those of the working population. "The only win-win solution to this problem," he said, "is for the GDP growth of the nations involved to grow sufficiently fast to generate a growing fiscal dividend sufficient to pay the IOUs coming due." Financial markets can help that happen by offering mechanisms that enable capital to be allocated to companies and industries where it can be the most productive. The result is structural changes in the economy, the development of start-ups along with the expansion of old firms, and the creation of new and appealing jobs. "The larger and more liquid an equity market is," Seifert emphasized, "measured in terms of its turnover ratio [that is, the average number of times a share changes hands], the faster the growth in per capita GDP. It's productivity that counts. Don't work harder, work smarter."
With a turnover ratio only a third of that in the United States, Europe has some catching up to do. The fault, however, is not with the continent's level of liquidity, according to Seifert. Instead, "there are simply too few companies guided by the invisible hand of the stock market. In Germany alone, some 2,500 companies that would qualify to go public are not listed on any exchange."
In rectifying that problem, Europe must deal with another one of considerable importance—its capital markets are fragmented into 42 exchanges (that total half the value of the U.S. market). "On the trading level," says Seifert, " we need a liquidity pool that gives us low-cost, cross-border access. To accomplish this, we are merging institutions and employing a single trading system. At the same time, we have to make sure that the back end of the operation keeps pace with the front end to avoid the costly control issues that exist today."
Looking ahead, Seifert sees the Internet as a force to be reckoned with in terms of costs and productivity. "The pool of potential buyers and sellers is greatly enlarged by the Internet," he concluded. "This will favor the cheapest suppliers and keenest buyers and thus hold down prices and inflation while raising productivity."
In his remarks, the NYSE's Cochrane underscored the ever-changing nature of the demands facing financial markets, from regulations to a demanding customer base that includes individuals, institutions, and broker/dealers. To meet these challenges, he said, the New York Stock Exchange has become "a very electronic market" whose technological capabilities make it the global low-cost provider.
Predicting that 24-hour trading will become a reality in the next two to three years, Cochrane suggested three ways to deal with it:
- Home-market adaptation. "If a company is based in, say, Germany, the home exchange will adapt to provide for the needs of that stock on a round-the-clock basis."
- Passing the book. Favored by the NYSE, this approach involves creating a network of partners around the world who would pick up business in their time zone as soon as an earlier one closed down. "At the end of a typical work day," Cochrane said, "the NYSE will have about 300,000 unexecuted orders on our books. Under this system, those orders would simply be rotated to our next partner and be completed."
- Global vendors whom the investor calls directly to execute a transaction.
With the coming of "stateless firms" in the world economy, Cochrane warned, the need for truly independent regulators is of considerable importance. The Securities and Exchange Commission (SEC) fulfills that function in the United States, but regulatory bodies abroad lack the clout of subpoena power and can be swayed by political connections. The best alternative, he suggested, would be to use central banks to oversee this function. As these and other processes are carried out, however, the United States should avoid the temptation to declare that what's good for this country is good for the world. "We have to figure out ways to harmonize with other national authorities in order to bring about procedures that work, rather than try to impose our will," Cochrane said.
A "Disruptive Technology"
Robert Gasser of J. P. Morgan completed the presentation by providing the perspective of the financial intermediary—a position, he said, that is being significantly challenged by what HBS professor Clayton Christensen has called "disruptive technology." In the United States, for example, there is a growing number of Electronic Communications Networks (ECNs)—competitive electronic national market systems that provide a broad group of constituents with seamless linkage and direct, cost-effective access to equities. As a result, Gasser added, the specialist on the trading floor of the NYSE might be an endangered species.
And be assured, he concluded, that in the not too distant future all intermediaries will be subjected to considerably more scrutiny from various directions. "We foresee a world in which investors evaluate firms and exchanges in real time on their quality of execution. And as U.S. markets become more fragmented thanks to new technology, regulators will step in to make sure investors are protected."