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Bridging Finance Without Fragmentation: A Comparative Look at Market Connectivity in the US, Europe and Asia

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Abstract

There are various reasons for attempting to create a capital markets union, and various avenues to do so. An important component is linking securities markets. This paper offers an analytical schema for understanding existing techniques for linking securities markets, a critique of the methods employed in the US National Market System (NMS) and EU Market in Financial Instruments Directive (MiFID) projects, and a comparative analysis of the models of linkage used in the Shanghai-Hong Kong Stock Connect and the ASEAN Trading Link, proposing eventual linking of the two systems, and concludes that it is the best model for linking securities exchanges. The primary critique I offer of the NMS and MiFID projects is that they fragment the market, disrupting both transparency and effective regulation, while offering their benefits primarily to the large broker-dealers in a position to profit from platform creation and exploitation. I explain that the alternative use of a concentrated matching model of linkage employed in China and ASEAN preserves market quality but places large broker-dealers under competition by introducing infrastructure that even small brokers can use. I find that the two Asian systems are interoperable, suggest that they be linked, and argue that such a direct linkage preserving liquidity and transparency offers regulators in Europe and the US a good example of what is possible, albeit probably not desirable for the large broker-dealers in their markets.

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Notes

  1. Markets thrive on increased network effects, so that an increase in the number of users can have a significant effect on liquidity, beyond any gains in economies of scale. See Stoll (2008) Future of securities markets: consolidation or competition? Financial Analysts Journal 64:15, at p 16. See also Arnold et al. (1999).

  2. See, e.g., Wurgler (2000), at p 189.

  3. See, e.g., Lamfalussy et al. (2001).

  4. See Andenas and Chiu (2013), at p 339, with further citations.

  5. See, e.g., Kang (2011).

  6. Ding et al. (2014), at p 22 (July 2014). See also Lipinsky and Ong (2014), at pp 6, 22.

  7. Ibid, at p 18.

  8. Le Leslé et al. (2014), at p 32.

  9. Le Leslé et al. use a probabilistic shock propagation model to show that cooperative complementarity is the scenario (when compared to competition among the two or hegemony of one of the exchanges) most likely to reduce the shock propagation risk in the Asian region. Ibid, at pp 21–25.

  10. S. Rep. No. 94–75, at 183 (1975); 15 U.S.C. §78 k-1(a)(1)(C) (2006).

  11. Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC (MiFID I). This framework has been replaced by a combination of a directive and regulation: Directive 2014/65/EC of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (MiFID II), and Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012 (MiFIR).

  12. Lyu (2015).

  13. These developments are discussed in Sects. 4 and 5 of this article.

  14. The ASEAN TL is discussed in detail in Sect. 5.2.

  15. Chernow (1990), at pp 304, 552, places the invention of the American Depositary Receipt in 1927 and attributes it to Guaranty Trust, latter purchased by J. P. Morgan and Company.

  16. See Coffee (2002), at p 1769.

  17. Karolyi shows that the company’s overall cost of capital drops with a cross-listing in the US, clearly indicating an impact between the US exchange and the original venue of listing. See Karolyi (1998).

  18. See the discussion in Gruson (2001), at pp 194–195. The ‘global share’ which the late Michael Gruson helped develop in the 1990s (see ibid, generally) is an alternative for direct listing of foreign companies in the US, but has not (yet) gained significant popularity.

  19. For the London Stock Exchange (LSE), see www.londonstockexchange.com, Statistics > Companies and Securities > List of All Companies (accessed 26 May 2015). For the Stock Exchange of Hong Kong, see Hong Kong Exchanges and Clearing Limited (HKEx) Factbook 2014, available at http://www.hkex.com.hk/eng/stat/statrpt/factbook/factbook2014/fb2014.htm (accessed 20 June 2015), at pp 19, 32.

  20. See Coffee (2002), Doidge et al. (2004) and Coffee (2007). A recent empirical analysis shows that following a US Supreme Court decision that curtailed the ability of foreign issuers to benefit from US enforcement mechanisms, there was no change (or a slight positive change) in foreign listings, indicating that the ‘bonding effect’ may not be the primary motivation for cross-listing in the US. See Licht et al. (2013).

  21. See Litvak (2009). Related reasons for secondary listing are increased visibility, given that a company listed on one of the leading equity markets is more likely to be picked up by international analysts in their research reports than a company which is not so listed.

  22. I write ‘almost none’ because the rules that exchanges and regulatory authorities develop for the listing of the first foreign companies will be in place to reduce the transaction costs of the companies that list at a later date. Analysts might also be more ready to publicise data and opinions on the foreign companies that later list on a market because of efforts expended by the pioneers of the international listing relationship.

  23. Schwartz and Francioni (2004), at p 93 (‘Historically, exchanges have been membership organizations, and for a membership organization … [t]he broker-dealer intermediaries … are their primary customers. With a membership organization, the other two constituents (investors and the listed companies) are important primarily because they are critical for the profitability of the members. Nevertheless, the bottom line is, with a membership organization, the interests of the intermediaries come first.’). Although this applies primarily to the older, mutualised form of securities exchanges, until non-financial issuers and funds take significant holdings in demutualised exchanges, this relationship of power is unlikely to change.

  24. ‘IFCs typically enjoy a strong degree of openness, presence of foreign entities, and connections to a wide range of international market participants.’ Le Leslé et al. (2014), at p 5.

  25. Group of Thirty (2009), Recommendation 8.

  26. Fidelity Funds, Annual Report and Accounts for the year ended 30 April 2014, at p 2.

  27. Ibid, at p 690.

  28. The linkage achieved through multinational fund investments should not be underestimated. As Tett notes: ‘In emerging markets … the Bank for International Settlements estimates that the top 20 global asset managers hold 30 per cent of all bonds and equities.’ G Tett, ‘Markets are parched for liquidity despite a flood of cash’, The Financial Times, 16 October 2014.

  29. Gilson and Gordon argue that for large pension and mutual funds, the governance-oriented activity will be limited to approving general measures rather than aggressively chasing specific initiatives: ‘[P]ension funds may engage in some governance activism but, like mutual funds, are rationally reticent about performance activism.’ Gilson and Gordon (2014), at p 10.

  30. In detail, these two programmes obviously have differences that derive not only from the differing nature of the legal systems in which they operate, but also from choices with regard to best execution and data consolidation (at least as expressed under MiFID I). For a discussion of differences, see, e.g., Petrella (2009).

  31. Securities Acts Amendments of 1975, Pub. L. No. 94-29, 89 Stat. 97 (1975) (codified as amended in scattered sections of 15 U.S.C. § 78).

  32. See 15 U.S.C. § 78q (2006), discussed at length in Donald (2011), at pp 54–59.

  33. See S. Rep. No. 94-75, 180 (1975) (‘… a number of causes for the securities industry’s languor in the face of great change and great opportunity: price fixing with respect to commission rates, artificial restrictions on market making activities, unjustified barriers to access to markets and market makers, opposition to market integration from powerful vested interests, monopoly control of essential mechanisms for dissemination of market information’).

  34. 15 U.S.C. §78 k-1(a)(1)(C) (2006).

  35. SEC Release No. 34-51808, Regulation NMS, 70 Federal Register 37496 (29 June 2005) (‘Reg NMS’), codified at 17 C.F.R. §242.600.

  36. SEC Release No. 34-40760, Regulation of exchanges and alternative trading systems, 63 Federal Register 70844 (22 Dec 1998) (‘Reg ATS’), codified at 17 C.F.R. §242.300.

  37. 17 C.F.R. §242.301(b)(3)(ii).

  38. MiFID II, Art. 4.1(21).

  39. An MTF is a matching venue ‘operated by an investment firm or a market operator’, MiFID II, Art. 4.1(22).

  40. OTFs are matching venues other than regulated markets or MTFs that match trades in ‘bonds, structured finance products, emission allowances or derivatives … in a way that results in a contract’. MiFID II, Art. 4.1(23).

  41. MiFIR, Art. 3(1).

  42. MiFID II, Art. 27(1).

  43. Angel et al. (2010), at p 5.

  44. ‘At one point post “MiFID I” coming into play there were nineteen separate trading venues for UK equities, while Europe became home to 27 exchanges and 19 MTFs.’ R Aitken, ‘How many exchanges does the world need?’, Forbes, 7 August 2014.

  45. Ferrarini and Moloney (2012), at pp 579–580.

  46. Ibid.

  47. Stoll (2008), at p 16. I write generally because the number of traders or even of orders present on an exchange at any given time will not always translate into increased liquidity for all traders. With high-frequency traders cancelling large numbers of orders, the raw order figures do not equal liquidity.

  48. Schwartz and Francioni (2004), at p 90.

  49. See Sect. 3.3 below.

  50. See Sect. 3.4 below.

  51. See Sect. 3.5 below.

  52. SEC (2013: 7).

  53. MJ White, ‘Enhancing our equity market structure’, 5 June 2014, available at http://www.sec.gov/News/Speech/Detail/Speech/1370542004312#.VF22AvmUdMA (accessed 20 June 2015).

  54. These are Credit Suisse, UBS, Deutsche Bank, Citibank, Bank of America, Morgan Stanley and Goldman Sachs. See The Financial Industry Regulatory Authority, ATS Transparency Data, available at https://ats.finra.org/ (accessed 20 June 2015).

  55. See European Securities Market Authority, MiFID Databases, available at http://mifiddatabase.esma.europa.eu/Index.aspx?sectionlinks_id=4&language=0&pageName=Home (accessed 20 June 2015).

  56. See Aitken, supra n. 44.

  57. See Securities and Futures Commission, Public Register of Licensed Persons and Registered Institutions, available at http://www.sfc.hk/publicregWeb/searchByRa?locale=en (accessed 20 June 2015).

  58. Tabb Group, ‘US equity market structure: Q1-2014 market metrics’, 15 July 2014, available at http://www.tabbgroup.com/PublicationDetail.aspx?PublicationID=1536&MenuID=44&ParentMenuID=2&PageID=43 (accessed 24 February 2015).

  59. ‘Years after they were set up to handle big trades purportedly ill-suited for public exchanges, dark pools drifted away from that goal and started handling more and more routine buying and selling, including small trades on behalf of individual investors.’ J Detrixhe, ‘Dark pool trade size doubles in Europe as venues hunt blocks’, Traders Magazine Online News, 4 February 2015.

  60. See Lewis (2014), at pp 115–116.

  61. See FINRA, Goldman Sachs Execution & Clearing LP Letter of Acceptance, Waiver and Consent, 5 June 2014.

  62. Complaint, The People of the State of New York versus Barclays Capital, Inc and Barclays plc, 25 June 2014, at pp 1–2.

  63. J D’Antona Jr, ‘UBS pays record $14 million fine for dark pool violations’, Traders Magazine Online News, 15 January 2015.

  64. C Sparrow, ‘Measuring predatory HFT’, Tabb Forum, 17 February 2015 (accessed 24 February 2015).

  65. Ibid.

  66. International Organization of Securities Commissions (IOSCO) (2011), at p 29.

  67. Ibid, at pp 29–30.

  68. Hoffmann (2014).

  69. See Lewis (2014), at p 206.

  70. London Stock Exchange, 2007 Annual Report, at p 23.

  71. London Stock Exchange Group plc, 2013 Annual Report, at p 34.

  72. London Stock Exchange, 2007 Annual Report, at p 23.

  73. National Market System Plan Governing the Consolidated Audit Trail Pursuant to Rule 613 of Regulation NMS under the Securities Exchange Act of 1934, 30 September 2014, available at http://www.sec.gov (accessed 24 February 2015).

  74. SEC Release No. 34–67457, Consolidated Audit Trail, 77 Federal Register 45722, 45725 (1 Aug 2012) (‘CAT Release’).

  75. Although the relative novelty of the field could be the cause of excessive jockeying among existing firms, we do see that the set of matching venues available at any given moment in time is not a constant. See J D’Antona Jr, ‘Wells Fargo shuts dark pool on volume drought’, Traders Magazine Online News, 20 October 2014; P Stafford, ‘Citigroup to close LavaFlow trading venue’, The Financial Times, 2 December 2014; J D’Antona Jr, ‘Fidelity, BlackRock and other fund managers set to launch new dark pool’, Traders Magazine Online News, 21 January 2015.

  76. MiFID II, Preamble 117.

  77. MiFID II, Art. 65.

  78. Discussed in the following Sect. 4.2.

  79. See, e.g., Shen (2013).

  80. Hong Kong Exchanges and Clearing Limited (HKEx). Shanghai-Hong Kong Stock Connect: Information Book for Market Investors, 26 March 2015, at p 3.

  81. BloombergBusiness, ‘China State Council said to approve Hong Kong Shenzhen link’, 8 May 2015.

  82. Shen (2013), at p 3. Individual investors may participate if they ‘hold an aggregate balance of not less than RMB 500,000 in their securities and cash accounts’.

  83. HKEx, Stock Connect Information for Investors, supra n. 80, at pp 5–7.

  84. A real difference between the SH-HK SC model and that in the NMS and MiFID is that orders originating in Hong Kong will still be matched in Shanghai. Given that the two cities are about 1230 km apart and that light travels at a speed of 299,792,458 metres per second, the transmission of an order would take approximately four milliseconds. The same latency would apply to the transmission of pricing information. A similar delay would not affect trading of NYSE-listed shares by a Palo Alto-based trader on an alternative platform in Palo Alto, because the order would be matched in Palo Alto, not in New York.

  85. Hong Kong Exchanges and Clearing Limited (HKEx), Shanghai-Hong Kong Stock Connect: Information Book for Market Participants, 13 April 2015, at p 48.

  86. Ibid, at pp 13, 29.

  87. For a detailed discussion of Hong Kong’s securities settlement system, see Donald (2012), Ch. 5.

  88. HKEx, Stock Connect Information for Participants, supra n. 85, at p 32.

  89. The CCP for the SSE is the China Securities Depository and Clearing Corporation Limited (ChinaClear).

  90. HKEx, Stock Connect Information for Participants, supra n. 85 (2014), at p 30.

  91. Ibid, at pp 15.

  92. Ibid, at pp 27–28.

  93. Ibid, at pp 28, 31.

  94. See HKEx, ‘Statistics show Stock Connect’s quota usage has been efficient’, HKEx News Release, 14 December 2014.

  95. These are Tsingtao Brewery Co Ltd, Guangzhou Shipyard International Co Ltd, Sinopec Shanghai Petrochemical Co Ltd, Shenji Group Kunming Machine Tool Co Ltd, Maanshan Iron & Steel Co Ltd and Beijing Jingcheng Machinery Electric Co Ltd. The convergence at the end of the period began after the SH-HK SC was announced.

  96. The data was generously provided by the Shenzhen Stock Exchange. Daily exchange rates were taken from the State Administration of Foreign Exchange (SAFE).

  97. See, e.g., Lee (2009).

  98. The bonding premium discussed in Sect. 2 of course refers to a reduction in the cost of capital for a company that lists on a better regulated exchange, not to the difference between the price in the two markets. However, because Hong Kong regulates all its listed companies and its law allows private and public action against the management of foreign companies listed on its exchange, the combination of these factors adds an additional layer to the Shanghai firm that dual lists.

  99. These companies include China Construction Bank Corporation, Industrial and Commercial Bank of China Ltd, Bank of China Ltd, Bank of Communications Co Ltd, Ping An Insurance (Group) Co of China Ltd, China Life Insurance Co Ltd, Agricultural Bank of China Ltd, China Pacific Insurance (Group) Co Ltd, China CITIC Bank Corporation Ltd, China Merchants Bank Co Ltd, PICC Property and Casualty Co Ltd, China Minsheng Banking Corp Ltd and China Cinda Asset Management Co Ltd.

  100. Nine of the 10 stocks with the highest turnover are in the group of 20 firms listed in Fig. 3: China Construction Bank Corporation, Industrial and Commercial Bank of China Ltd, Ping An Insurance (Group) Co of China Ltd, China Life Insurance Co Ltd, Agricultural Bank of China Ltd, China Pacific Insurance (Group) Co Ltd, CITIC Securities Ltd, China Merchants Bank Co Ltd and China Minsheng Banking Corp Ltd.

  101. Ding et al. (2014), at p 22.

  102. Ibid, at p 18.

  103. Le Leslé et al. (2014), at pp 4–11, 32.

  104. Ibid, at pp 4–11, 12.

  105. See HKEx Factbook 2014, supra n. 19, at p 15.

  106. Le Leslé et al. (2014), at p 14, Panel 2.

  107. Ibid, at pp 21–25.

  108. See the AEC Blueprint (2007) §A4, available at http://www.asean.org/archive/5187-10.pdf (accessed 20 June 2015).

  109. The contents of this Section are based on conversations with officials from the Stock Exchange of Singapore (SGX) and the Monetary Authority of Singapore, who generously provided me with interviews and data to clarify a number of central issues regarding the ASEAN Trading Link.

  110. All of these measures are provided for in concept by the AEC Blueprint, and information on the separate initiatives can be obtained from the ASEAN Capital Markets Forum, available at http://www.theacmf.org/ACMF/index.php (accessed 20 June 2015). The investment fund ‘passporting’ scheme contains the expected ingredients of partial harmonisation, mutual recognition and some light regulation by the host state. See Handbook for CIS Operators of ASEAN CISs, 25 August 2014, at p 3.

  111. The variety of arrangements, which are not memorialised in any public document by ASEAN or a member state, closely parallel in structure those arrangements described by the EU under the rubric ‘direct electronic access’: ‘an arrangement where a member or participant or client of a trading venue permits a person to use its trading code so the person can electronically transmit orders relating to a financial instrument directly to the trading venue and includes arrangements which involve the use by a person of the infrastructure of the member or participant or client, or any connecting system provided by the member or participant or client, to transmit the orders (direct market access) and arrangements where such an infrastructure is not used by a person (sponsored access)’, MiFID II, Art. 41.

  112. Information on the SunGard data transfer system is available at SunGard Global Trading Insights, Simplicity, scale and the single network. The ASEAN Trading Link explained, 2011, available at http://www.sungard.com/~/media/02E263845E5D4FCCACDA799A51636C76.ashx (accessed 24 February 2015) and http://financialsystems.sungard.com/resources/capital-markets/articles/single-network-the-asean-trading (accessed 24 February 2015).

  113. I have been told that Deutsche Bank has agreed to act as a global custodian for brokers participating in the ASEAN TL, and it may be possible for Deutsche Bank to net deliveries of cash among its ASEAN TL customers.

  114. Data regarding the total trades executed within the ASEAN TL is gathered, but is not yet made publicly available for study.

  115. The ASEAN Capital Markets Forum programme for the mutual recognition of qualifications and licensing of broker-dealers among ASEAN member states is discussed at ASEAN Capital Markets Forum, ACMF Initiatives > Cross-Recognition of Qualifications on Education and Experience of Market Professionals. Available at http://www.theacmf.org (accessed 28 May 2015). Agreements reached under this programme have also been memorialised through memoranda of understanding between national regulators.

  116. Long Finance, The Global Financial Centres Index 16 (September 2014), at pp 5–6.

  117. Since 2010, the semi-annual rankings for Hong Kong and Singapore in the Global Financial Centres Index have been (HK then SG): 2010—739 v 733, 760 v 728; 2011—759 v 722, 770 v 735; 2012—754 v 729, 733 v 725; 2013—761 v 759, 759 v 751; 2014—761 v 751; 756 v 746. The Global Financial Centres Index, Numbers 7–16.

  118. For example, in 2012, the World Economic Forum, in a ranking that specifically included quality of regulation, classified Singapore the fourth most competitive financial centre in the world at a time when it ranked Hong Kong as the first. World Economic Forum (2012), at p 12.

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Acknowledgments

I would like to thank the Hong Kong Research Grants Council for the generous funding of this work under the Theme-Based Research Project ‘Enhancing Hong Kong’s Future as a Leading International Financial Centre’ (T31–717/12-R). I would also like to thank the Shenzhen Stock Exchange for extensive price data on shares dual-listed in Hong Kong and mainland China, ‘Ri’ Ren Xinyu for his excellent processing of that data, and the Singapore Stock Exchange and the Monetary Authority of Singapore for providing me with information about the ASEAN Trading Link.

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    David C. Donald (Professor)

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Donald, D.C. Bridging Finance Without Fragmentation: A Comparative Look at Market Connectivity in the US, Europe and Asia. Eur Bus Org Law Rev 16, 173–201 (2015). https://doi.org/10.1007/s40804-015-0011-1

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