Table of Content I. INTRODUCTION II. CHANGES TO SECURITIES MARKETS AND TRADING A. The Break-Down of the Exchange Monopolies and Fragmentation B. Consolidation: The Rise of Global Stock Exchanges C. Cross-Border Trading and Interconnected Trading Platforms D. Increased Trading in Derivatives E. Increased Trading Volumes and High Frequency Traders F. Direct Electronic Access G. Hedge Funds III. THE IMPACT OF THE CHANGES ON MARKET INTEGRITY A. Risks Inherent in the Changes B. Challenges for Regulators C. Are the Changes to Markets and Trading Actually Increasing Instances of Market Abuse? IV. HOW HAS REGULATION OF TRADING AND THE SUPERVISION OF MARKETS ADAPTED TO THE NEW ENVIRONMENT? A. Closer Supervision of Markets by Government 1. Consolidation of Regulatory Functions and its Impact on Market Integrity 2. Cross-Border Market Surveillance B. Recent Regulatory Changes Which May Impact on Market Integrity 1. Hedge Funds Regulation 2. High Frequency Trading and Direct Electronic Access 3. OTC Derivatives V. HAS THE REGULATORY RESPONSE BEEN SUFFICIENT? VI. CONCLUSION I. INTRODUCTION
Stock market trading around the world has undergone a significant transformation in the last few decades. Institutions and even individual investors now have access to a much vaster array of products, markets and trading venues than they did just 30 years ago. Brokerage costs have fallen and the time taken to execute a trade has been reduced to a fraction of a second. Falling costs and rapid execution times have resulted in new participants entering the markets contributing to significant increases in trading volumes.
These changes have largely been driven by competition between markets, which has resulted in reduced brokerage costs for traders and listing costs for issuers. Competition has also increased liquidity, reducing the spread between buy and sell orders which in turn decreases the profits which can be made on such spreads. As the profits on such spreads are earned to the detriment of others, improved liquidity also benefits traders and investors. At the same time competition has resulted in the development of new products as investors seek new ways to improve the returns from their investments.
Securities regulators have mostly welcomed these developments, as their key objectives include promoting market efficiency. (1) However the goals of securities regulators extend beyond promoting the efficiency of markets to also protecting the integrity or fairness of the markets. (2) The job of a regulator in protecting market integrity is somewhat open-ended and perhaps extends to a duty to ensure that the market is fair for all participants. However, as a minimum, protecting market integrity encompasses the elimination of dishonest practices such as market manipulation and insider trading. (3) There is a compelling public interest in regulators taking action to maintain and improve market integrity. Securities markets are vital mechanisms by which corporations can access funds from investors in order to grow. Such investment is dependent, to a large extent, upon investors having confidence that the market is fair. Market integrity is therefore important to promoting investment, which is, in turn, important to the economic development of a country.
As the changes to markets over the last few decades have been largely spurred on by efficiency concerns rather than in the interests of protecting the integrity of markets, a question that needs to be asked is what impact have these changes had on market integrity? Have the changes made markets less fair by making them more susceptible to market abuse such as insider trading and market manipulation? If so, have regulators sufficiently addressed this issue? As a result of recent crises in securities markets, securities regulators have been active in tightening regulation. However, most of the focus of these new regulations has been directed towards a relatively new, and different, regulatory goal--that of reducing systemic risk. (4) Systemic risks are "risks that occasion a 'domino effect' whereby the risk of default by one market participant will impact the ability of others to fulfil their legal obligations, setting off a chain of negative economic consequences that pervade an entire financial system.' (5) While some of these new regulatory changes directed towards systemic risk concerns may have incidentally also worked towards improving the integrity of the markets, this has generally not been the objective.
The purpose of this article is to outline the main changes to securities markets and securities market trading that have occurred in the last few decades and to consider how these changes may have impacted market integrity. In particular, have these developments resulted in more opportunities for persons to engage in insider trading and market manipulation that will go undetected and/or not be prosecuted because the perpetrators have been able to obscure their trades across markets and/or different securities? What has been the response of regulators? To explore these issues, Part II outlines the main changes that have taken place in stock markets and securities market trading over the last few decades that may have impacted market integrity. Part III considers the risks to market integrity inherent in these changes. Part IV details the changes in both the architecture of securities regulation and specific regulatory measures which may work towards preserving market integrity. Part V then seeks to analyze the regulators' responses and whether they have been sufficient. The article concludes by arguing that up until recently, the impact on market integrity has been largely overlooked by regulators in supporting the changes to the markets. If regulators are to maintain and improve market integrity in this new and ever evolving trading environment they likely need to do more. In particular, more needs to be done to collect trading and other data in a standardized form, to establish procedures and systems to exchange and analyse this data to detect market abuse and to bring enforcement proceedings in relation to such market abuse.
II. CHANGES TO SECURITIES MARKETS AND TRADING
The Break-Down of the Exchange Monopolies and Fragmentation
Securities markets today bear little resemblance to the stock exchanges which operated up until the 1970s and 1980s. Up until that time exchanges around the world were physical trading floors, operating within their own protected, often monopolistic, environment typically defined by national boundaries. While a few exchanges were run by governments, most exchanges were private mutual organizations owned and operated by brokers. (6) Those exchanges were largely self-regulated and subject to only a limited degree of government oversight. Although this system of a single or very few private exchanges for each jurisdiction was largely anti-competitive, it was allowed to continue as it delivered a number of benefits:
Governments benefited as they were able to regulate the securities market without the cost and trouble of setting up a very extensive system of supervision and enforcement. Stock exchanges benefited by being recognized by government as the means through which the securities market was regulated. Their members benefited as this enhanced position limited or removed competition, so allowing them to pass on their costs to buyers and sellers of securities. Investors benefited as they had access to a regulated market in which the risks of default or fraud were much reduced. Issuers of securities benefited as they continued to have access to a market where the stocks and bonds they created could be traded. (7) Nevertheless this anti-competitive environment was not without critics in that, like other anti-competitive environments, exchanges were able, or at least had the capacity, to exercise the power of a monopoly. This gave the exchanges and the member brokers the ability to stifle innovation and make monopolistic profits from high charges levied on brokers, issuers and investors.
Towards the end of the twentieth century, exchanges increasingly came under pressure to change. These changes were influenced first by the fact that from the 1970s institutions took over from individuals as the main investors in securities.The number and size of such institutions grew dramatically from the 1970s as it became apparent that government benefits for retirement would become less generous in the future, thus compelling individuals to make their own provision for retirement, often through the use of mutual or pension funds. (8) Competition between such funds put pressure on funds to obtain high rates of return. As part of their push to increase returns, these institutional investors pressed governments for changes to the anticompetitive fee structures of exchanges. As a result, governments gradually required the existing exchanges to abandon their anti-competitive practices, including fixed commissions and restrictive membership requirements. (9)
Another driver of change was the dramatic improvements in communications and trading technology, and, in particular, the movement from trading floors to screen trading systems. (10) This move to electronic trading enabled the establishment of new regulated exchanges and alternative trading systems (ATS) (11) as barriers to enter the market for securities trading fell. The impetus for establishing ATS (also called electronic communication networks (ECNs)) also came from reduced fixed costs, for example location costs, compared to regulated exchanges, and by the fact that they often had a lower cost regulatory framework. (12) Established exchanges also faced increased competition from expanded over the counter trading (OTCs). (13) Although OTC dealings have existed for most of the twentieth century, increased technology and communications allowed their expansion. (14) Like ECNs, OTCs have competitive...