August/September
2002 - CER BULLETIN, ISSUE 25
NEW RULES FOR CAPITAL MARKETS By Alasdair Murray
The fallout from
the Enron and WorldCom corporate scandals in the United States will resonate
through global securities markets for years to come. On this side of the Atlantic,
however, the European Commission is quietly preparing legislation that may have
just as profound an impact on the evolution of European securities markets over
the next decade.
The Commission is working on a major revision to the investment services directive
(ISD) - the cornerstone of EU legislation for investment firms and securities
markets. The directive, which came into operation in 1996, seeks to supply investment
banks and securities exchanges with a 'passport' to trade unhindered across
the EU's single market.
The EU needs to revise the ISD to create a fully functioning single market in
stocks and shares - and thus curb the cost of cross-border trading for investors,
and of capital for European businesses. The principles behind the ISD are based
on the structure of the securities industry in the late 1980s and are likely
to slow future developments in the sector. Most of Europe's exchanges were at
that point member-owned organisations, which enjoyed a near monopoly in the
trading of domestic securities. New technology has made it possible for new
entrants to move into the market and challenge the dominance of the traditional
national exchanges. In some EU countries, most notably Britain, investment banks
are also acting as quasi-exchanges by matching buy and sell orders on their
own books - a practice known as 'internalisation'.
The established exchanges, such as Deutsche Börse and the London Stock
Exchange, have responded to growing competition. They have turned themselves
into private companies and updated their own technology to ensure they can provide
cheaper and better services to the growing pool of EU and international investors.
The once stark difference between exchange, investment bank and other investment
service companies, such as information providers like Bloomberg and Reuters,
is now increasingly blurred. The ISD is also marred by a number of serious drafting
flaws which are hampering the EU's efforts to establish a fully functioning
single market in securities. EU governments only reached political agreement
on the directive after six years of tortuous negotiations. As a result, the
ISD contains a number of messy compromise clauses - many of which have protectionist
implications. Member-states, for instance, are able to prevent 'new markets'
from operating in their jurisdictions - although the text never clearly defines
what constitutes a new market.
The Commission's tricky task is not only to revise the ISD to ensure it takes
into account this complex new market architecture, but also to leave sufficient
flexibility to allow further evolution in European securities markets. In particular,
the Commission will have to balance the competing claims of the investment banks
and the exchanges for preferential treatment in the new directive.
For example, the banks and the exchanges are at loggerheads over the practice
of internalisation. Some of the exchanges - most notably Euronext - argue that
internalisation should be either banned or heavily regulated, on the grounds
that it damages both the quality of the overall marketplace and harms individual
retail investors. If investment banks conduct a large number of trades on their
own books, the number transacted on the main market - and consequently visible
to all investors - will decline. As a result, investors who trade on the main
market could find it more difficult to buy and sell their shares.
Equally, a bank may face a potential conflict of interest by trying to act as
both broker and exchange when it internalises an order. As a broker, the bank
is supposed to secure the best possible price for its clients. However, the
bank has an incentive to conduct the trade on its own books, even if it could
achieve a better price in the main market, as it profits from not paying exchange
fees. The bank may also raise extra revenues on the difference between the price
it conducts the transaction internally and that on the main market.
However, the banks argue that they will be able to pass on much of their cost-savings
to their customers, further reducing the cost of trading for investors. And
they claim that any attempt to restrict internalisation would reduce competition
and raise the costs of securities trading in the EU. The two sides have begun
a fierce lobbying battle on this issue. The Commission, however, should heed
the recommendations of the Lamfalussy Committee on Financial Regulation and
resist the temptation to try and provide a comprehensive legislative answer
to the internalisation problem. The Lamfalussy Committee stressed that the Commission
should concentrate on enshrining broad principles in EU legislation, leaving
committees of experts to design flexible detailed rules. Any attempt by the
Commission to 'micro-manage' securities regulation would be counter-productive:
rigid rulebooks are extremely difficult to enforce and may hamper future innovation
in the markets.
The Commission's focus should be on removing the remaining legislative obstacles
to cross-border trading - in particular, those clauses which could be used in
a protectionist manner. The Commission must also make sure that all firms which
operate exchange-based systems - whether they are traditional securities exchanges,
new technology-led trading systems or investment banks - compete on a level
playing field. Firms which supply similar services should face the same regulatory
obligations.
In terms of the internalisation debate, this means the Commission should not
intervene to prevent investment banks from transacting orders on their own books.
Nor should the Commission try to set out detailed rules for banks which practice
internalisation in the revised ISD. Rather, the Committee of European Securities
Regulators - the EU's key regulatory group - should, after suitable consultation,
establish new rules of conduct for investment banks. In this manner, exchanges
and banks can compete fairly for securities transactions, while retail investors
can remain confident that banks will not abuse their role as brokers.
Above all, however, the successful reframing of the ISD will depend on member-states
playing a constructive role. The US corporate scandals may furnish member-states
with an excuse to preserve some protectionist features of the ISD, dressed up
as 'investor protection'. In particular, member-states may attempt to hold on
to their catch all powers to intervene for the 'general good'. However, any
moves to restrict cross-border competition in European securities markets could
increase the costs of trading for all investors and raise the cost of capital
for business. EU governments should remember the commitment they made at the
Lisbon summit in spring 2000 and endeavour to complete the legal framework for
a single market in securities by 2005.
Alasdair Murray is director of the economics and
social policy unit at the CER.
