Review Reveals UK Equity Markets Malaise

Terry Flanagan

Respondents to a government-sponsored review of UK equity markets were highly critical of high-frequency trading and exchange-traded funds, in particular.

The interim report, published yesterday by Professor John Kay at the behest of Vince Cable, the UK’s business secretary, revealed that the majority of British asset managers and pension funds were sceptical of these trading strategies.

Kay also received strong lobbying on contentious issues such as short-selling, foreign takeovers, executive bonuses and boardroom diversity. Another aspect that drew particular criticism was quarterly reporting, which some business leaders said may be having an adverse effect on the behaviour of companies and shareholders.

The comments and proposals discussed in the report signal areas of interest for the final report but do not represent its provisional conclusions. Kay is not making recommendations at this stage but will present his final report, including recommendations for action, to Cable later this year.

One of the respondents, Domenico Ferrini, co-chief investment officer of Investec Asset Management, said: “Persistence of high volatility events is a negative for equity markets and long term investors as higher risk will demand a higher rate of return. We look to the proliferation of aggressive high-frequency trading strategies and passive strategies, particularly exchange-traded funds, as the probable source of this increase in high standard deviation events.

“We also point to the systemic risks that have emerged from these trends. High-frequency traders are able to access trading information ahead of the general market by effectively paying exchanges for server co-location ahead of the general market which allow them to adopt aggressive trade discovery tactics and as a result increase the market impact of trade execution for longer term investors and hence long term investors’ overall costs.”

Asset manager Aviva Investors, in its response, said: “While proponents of high-frequency trading argue that it provides liquidity to the market, there is evidence to the contrary. High-frequency trading is positively correlated to share price volatility, which high-frequency traders exploit aggressively. We do therefore feel that steps need to be taken to curb the focus on trends that seem to dominate capital markets.

Aviva also expressed its concerns over the rise of exchange-traded funds and the distorting effect they are having on the markets. It said: “ETFs are increasingly representative of short-term speculation and, as the trend moves away from plain vanilla ETFS, we are inclined to agree. As synthetic ETF production continues apace in Europe this can, amongst other things, be expected to play an increasingly important role in the existing short-term dynamics of the market.”

Respondents were also worried that the advantages of increased competition in share trading between multiple venues, brought about by the European Commission’s 2007 Markets in Financial Instruments Directive, may not be quite as advantageous as that envisaged by the regulators.

Kay said: “In a number of discussions, participants expressed regret that the older model – in which the exchange was a utility, existing to serve the needs of market participants in the first instance then the economy more generally – had been displaced by one in which exchange services were a standalone business.”

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