U.S. Market Position Under Attack

Three interesting news pieces came across my desk today: the acquisition of Instinet by Nomura; the development of a Pan-European MiFID-ready exchange; and a story about European exchanges and depositories promising to open up their vertically aligned clearing businesses, prompted by the European Financial Services commissioner, Charlie McCreevy, to promote cross-border clearing and settlement competition, innovation and lowered cost.

These three stories -- in conjunction with the Markets in Financial Instruments Directive (MiFID), the $22 billion IPO of the China Construction Bank and numerous stories about Sarbanes-Oxley (SOX) pushing financial markets business to London -- represent no less than a full-out assault on the U.S. position as the financial markets capital of the world. The SOX challenge has been snowballing for the past two years, as the U.S. equity markets last year had net negative equity issuance of almost $200 billion (according to the SIA and Thomson). And this year looks worse -- much worse.

A handful of privatizations and a few global IPOs, however, should not make us too worried about the States' financial prowess if the Europeans continued their heterogeneous and territorial ways. But MiFID is beginning to harmonize the European financial markets into a cohesive European Community.

One of the major tenets of MiFID is the elimination of the exchange concentration rules, which make it difficult for electronic trading platforms (ECNs, ATSs, etc.) to gain a foothold in major European markets. Hence, post-MiFID, platforms such as Equiduct (the newly announced Pan-European exchange mentioned above) will have an easier time gaining momentum and liquidity.

But if European exchanges and depositories continued their strong vertical alignment, homogenizing the European financial community and eliminating the concentration rules would not make much difference. Vertical integration means that the exchange and the depository are tightly aligned. This is good for trading within the exchange infrastructure. However, once one side of the trade is executed outside of the vertically aligned exchange/depository (in another exchange), then clearing and settlement becomes difficult and expensive.

When securities are bought through one depository and sold through another, even though the investor has no market risk or trading position, the investor actually has both a long position and a short position in different depositories. To flatten out these positions, the long position must be transferred to the depository that is short. With these movements come fees not only from depositories, but also from clearing banks and custodians. These transfer fees and roadblocks have made developing new European exchanges uneconomical.

This is why the McCreevy agreement is important. If the agreement enables the creation of a Pan-European depository (or at least decoupling the exchanges from the depositories, making them more competitive and less expensive), then new exchanges/ECNs/ATSs will have an easier time competing and actually may have a chance at being successful. This would be bad luck for the U.S.

Not only will SOX push firms to list overseas, European exchange infrastructures also will be more efficient, making it less expensive to trade overseas. This has the dual whammy of drawing both banking and trading to London. So be prepared: If we don't get this straightened out soon, we may have to get our quid to take the Tube past the Bobbies on our way to the City -- and I don't mean New York, as the global financial capital may truly move across the pond. Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio