How do you think improving financial information and reporting could help avoid another global financial crisis?
KRANTZ: I think improving financial information and reporting can minimize mistakes, estimates and catastrophes. One of the biggest remaining problems we all have in the exchange world, or we as investors or as issuers, is that we still do not know what is “out there”. There are minefields in the OTC, off regulated exchange environment, whose valuations we are still guessing at. As with the JP Morgan Chase disaster a couple of weeks ago, unknown things blow up. One of the areas of involvement the World Federation of Exchanges (WFE) had over the last thirteen years was drawing the attention of the public authorities around the world to the OTC question. We were seeing things go wrong in our part of the regulated capital markets environment. It was clear to us we did not know what was there, whereas the on-exchange regulated environment presented market prices for all to see. We were feeling things out there in the gray zones, and over the years we asked the Basel Committee, IOSCO, the International Federation of Accountants, and the G20 about these matters. The answer came back was that as “sophisticated investors”, the parties to these OTC transactions “know what they are doing.” Yet, we could see that no one could price it, because we could not price it and exchanges do pricing. The more clarity we can put on that, the safer the marketplace for all; and so I would encourage regulators to continue to extend the regulatory periphery, as I have been doing in years past when at World Federation of Exchanges. This would include encouraging accountants in companies and their statutory auditors to go in and verify these unregulated contractual commitments to decipher what the numbers are about. They are there, very widely spread across the world’s financial system and on corporate books. However, it is a very large unknown, and OTC is about 8-10 times larger than the derivatives traded on the exchange. There are a lot of unknowns, and one of the unknowns is even a reckoning of all that there is.
How well coordinated is the global financial ecosystem?
KRANTZ: One thing that has troubled me is that by 2007 the WFE was already going to the Financial Stability Forum (now the Financial Stability Board, or “FSB”), which serves as the secretariat of the G20. It was time to start explaining with the mortgage problems in the US, without going any further, what the exchanges were doing in response for providing liquidity to the world’s equity markets when there was so much illiquidity everywhere else. By 2008, the regulated exchanges were the largest ATMs in the system, and it seemed to World Federation of Exchanges that everyone was coming to trade stocks to withdraw the cash blocked elsewhere. On exchanges, you could still get your cash out. The more I explored it, the more it seemed to me that it was about banks rather than the whole financial system. Therefore, when working on behalf of exchanges I began to get help elsewhere. This came mainly from the French Treasury, because the WFE is in France, a G20 member country. My problem in observing the G20 meetings is who is at the table with our government officials: there are central bankers, absolutely, and of course ministries of finance. But at this February’s 20 conference, there were a lot of commercial banks, and this is where the troubles are. There was very little capital market presence, and very little capital market authority presence. The insurers, public funds, and pension funds were all absent. I am not seeing enough of a sense that we are drawing together, as a whole, the ecological system that is our global financial system. The question is why are we not all at the table on a more regular basis? We are not going to solve these issues until we do that.
What are your comments on Western nations’ exchanges being at a cyclical low in terms of trading volumes?
KRANTZ: We are in a very funny position in the world. If you say Western, I understand it as North Atlantic, on both sides, such as the EU, US, and Canada. What has happened over the last 15 years with regulatory change was the fiat to smash apart the exchange as the central public marketplace. The exchange used to be the only place for trading. By allowing other execution platforms with their different regulatory responsibilities, you allowed the idea that exchanges needed to compete. The problem is there are many other rules and obligations for these other platforms, and it is nowadays very hard to piece together a picture of what is happening in the marketplace, which has come to resemble a Rube Goldberg puzzle. The case we made at the WFE was based on the “Flash Crash” of May 2010. It took the United States SEC (Securities and Exchange Commission) and CFTC (Commodity Futures Trading Commission) four months to find the ostensible trigger event. That is not live surveillance, or even end of trading day evaluation. That is not what I would have expected from the capital market authorities that are supposed to be watching over the marketplaces to be able to catch errors. A four-month search for an event like that proves that the authorities can no longer see and master the overly complex market structures they have encouraged to come into place. I do not know how all the bits and pieces add up. We the ordinary public are not seeing prices being formed clearly, which in my view is an absolute economic disaster, because the one thing an exchange does is provide critical and unique macroeconomic information in the form of pricing. Publicly visible, multilateral price formation has, in these marketplaces, been split apart by regulatory fiat in the name of uneven competition.
What are the first steps towards finding a solution for structural reform?
KRANTZ: There are similarly serious questions to be addressed in the EU. When I talked with capital markets officials at the French Treasury about how they view things, the regulatory fiat in the European Union came from Brussels; it was not happening at the national level. The people I spoke with were rather certain that there is no going back to simpler capital market structures, because the EU authorities would have a hard time admitting to what I would consider a horrible mistake. How do you break a national public good, like price formation for an economy? Yet this is what they did. They tried to at least minimize the most egregious effects of the problem through MiFID II review, as the as the directive is known. My concern is that with this very unclear superstructure for the capital markets, the EU is going to be hobbling along for a while. As places of capital formation, these different kinds of platforms will poorly price information for all users. Thus issuers have less of an idea of who is doing what in their securities and what kinds of market interest there is. If you are a company chief financial officer, you want to know what is going on in your securities: you want a further rights issuance, or you may be trying to buy back shares. Either way, you need information from market activity and market pricing, and this is being diminished by the structure questions in Europe and the US. I am hoping that the rest of the world carries on with simpler structures, which is all it takes to form capital in the primary market and price it afterwards. I know that was a lot of my mission when I was at the WFE. I wanted to keep the effects of fragmentation out of the rest of the world, and we had some talks about that here at the Kuala Lumpur conference.
As the West faces a financial crisis, where does that leave the Asian markets?
KRANTZ: I hope healthy, and I hope that the lessons have been understood. You do not want to break a national infrastructure asset like price discovery on a multilateral basis. Along this line, we had a great conversation in Moscow two years ago. The then- head of the securities commission had a question for us and asked, “When I look west from Moscow, why on earth are you people breaking up your markets? We waited for 70 years in Soviet Russia to have a market price as opposed to a government fiat price that was not very meaningful. Now we finally have the opportunity, and we are certainly not going to be imitating you”. I am hearing similar points here in Kuala Lumpur, with managers saying they do not want that, or they cannot afford that. I have heard other people in the Middle East say forget about London and New York as capital markets models, because they cannot afford those losses. There is a sense that the new way of the kinds of platforms introduced in the US first, then in Europe, is not the way a lot of the rest of the world wants to be going. It is very costly when you lose market integrity. I, for one, can no longer follow or make a diagram of the capital market structure in Europe or the US. It does not fit on one page, and I am not clever enough to figure out all the different actors. I am afraid it got out of control, because I am supposed to be able to understand these things.
Is the root of the financial crisis a failure of the central banks?
KRANTZ: No, it would not be the central banks. It would have been capital markets authorities who have denigrated the idea of an exchange in the following sense. An exchange, to my mind, was a place where a lot of things happened so that in the end the public would get the fairest possible price for assets. There were a lot of processes involved. You had rules for issuers. The issuers had to give certain information on an ongoing basis. Then you had the trading platform, the clearing matching the trade, the settlement, and you had market surveillance and a complaint mechanism. If you got a bad deal you could go to get your trade corrected or say you want your money back. Though it is very hard, you also had, when things went wrong, the ability to cancel trades that were obvious errors. There were protections for investors. If you remember the writing on the US SEC wall at the entrance to the building in Washington it says “We protect the investor”. It was a whole package of things that altogether made for a very distinct public institution, a regulated exchange. But sometime in the late 1980s in Washington, someone got the idea that it was about something else, something less; that it is was only about order execution. They thought the exchange did not do much else of value, and if you are involved only in order execution you do not have the package around it. The understanding of public good of an exchange began to slide from there. It was those people who had an interest in executing orders but not being in an exchange with all those regulatory constraints and costs that would have led to having this fundamental idea questioned by the authorities.
Were regulatory changes the core reason many exchanges got away from their non-execution activities? What effect has consolidation had?
KRANTZ: The exchanges themselves did not get away from regulation. They were obliged to keep going by their statutes, and because an exchange is all this, the business of operating an organized market in a regulated environment. One of the things that did surprise me in my stay with the WFE was NASDAQ, which did not have an exchange license for years, finally went ahead and got one five years ago. There was still value in having the exchange license for reputational reasons, and at the same time, it was running a multitude of other kinds of execution platforms trying to catch different clients in various ways. Exchanges did not lose track of who they were. It was other actors entering their near space and providing lesser forms of capital market activity with less regulation, less rules, and different rules that tipped the capital formation process. Certainly, there were other problems in financial services, and notably information disclosure was often bad. Exchanges have not gotten away from that.
Consolidation seems to be off the table at the moment for a couple of reasons. Business consolidations do not often work, no matter the industry. There is a lot of money spent on M&A that is, in my view, not so successful. There was a lot of national consolidation within the exchange industry over the last twenty years, and that has proven rather more successful. The Swiss exchanges came together, but the German exchanges have not, although they are all allowed to use the Frankfurt system. They have decided that there is an interest in regional work with staying close to issuers or particular products. The Brazilian exchanges did merge. The French exchanges also merged over the years. The US has not merged for various reasons, and in fact, there are new exchanges getting licenses in the US. There is no neat picture to draw on in terms of consolidation. My working assumption as to why there is not more cross border consolidation among large players is the depth of the crisis. Tax payers are on the hook for a lot of big institutions at the moment, though not exchanges; but in the public eye, exchanges may have been thrown in with other kinds of institutions. What was global, and seemed to be great in many ways about cross border work, might be very hard when you are dealing with exchanges as national infrastructure. There is still something about the name, “exchange, “which matters as a rock within the national economy.
I have heard other people in the Middle East say forget about London and New York as capital markets models, because they cannot afford those losses. There is a sense that the new way of the kinds of platforms introduced in the US first, then in Europe, is not the way a lot of the rest of the world wants to be going. It is very costly when you lose market integrity. I, for one, can no longer follow or make a diagram of the capital market structure in Europe or the US. It does not fit on one page, and I am not clever enough to figure out all the different actors. I am afraid it got out of control, because I am supposed to be able to understand these things.
Are the reasons that have been given by authorities when rejecting cross-border exchange mergers valid?
KRANTZ: I got very irritated by the reason given by the European Commission, and it had to do with something I said regarding the OTC. The top line reason communicated for the NYSE (New York Stock Exchange) or Deutsche Boerse merging was derivatives growth. They are major players in derivatives around the world. This is growing faster than the bond segments, the cash equity segment, and just about anything else. This is for reasons of computer power, familiarity, and that you do not have to put up all the cash, you can just put up your margin and your existing one hundred units of cash goes further. You can multiply the effect through the leverage. These are all good reasons. The reason for the turn-down by the European Commission was that it would have a dominant position in European derivatives. This is nonsense. It would have a dominant position on exchange listed and exchange traded derivatives, but that is ignoring the OTC which is eight to ten times bigger than what is transacted on exchange. How can you dominate when you are only 15-20%? I found this the wrong reason to turn it down. What the right reasons would have been I do not know, but if that is all they could come up with the deal should have gone through.
Where do you think has the right mindset?
KRANTZ: In terms of where to look, and pure business model, we had many debates over the years about whether the exchange should be vertically integrated, beginning to end, or horizontally integrated, going across regions. It seems through the last five years with the vertical model, which was largely developed by Deutsche Boerse about 18 years ago, has won. It is solid. The exchange is able to master the processes all the way through. Therefore, the ability to identify risks becomes embedded in the structure. This has been copied largely by many other institutions across the world. I am very glad to see more solid institutions in the industry. In terms of regulatory quality, the number one for the World Economic Forum for the last few years is the Johannesburg Stock Exchange. When it is the World Economic Forum it is not just laws on your books. It is because you are commercially viable in a well regulated environment. The distinction awarded has been for the commercial vigor of the place, and we would look there for examples because it is very innovative in financial reporting, too.
We would look at a lot of the commodity exchanges that are growing. Commodities are in some form of super cycle. When I get pressed on high food and energy prices my answer is to thank exchange traded pricing, because that is probably where the market equilibrium for supply and demand is, and we need to know that. The commodities exchanges are taking off nicely in different parts of the world, in different currencies. I would prefer to see more foreign exchange trading on exchange, as opposed to inter-bank, and to see that market become more organized and visible. I am sensing that there will be important adjustments relative to currency values here in Kuala Lumpur as they develop the ASEAN class.
There is creativity in Middle Eastern exchanges, particularly in the Gulf. They are putting the exchange idea to new uses. They have been finding that their wealth needs good pricing. The exchange idea is spreading in new circumstance. I am thinking of how well the Polish Exchange has done over the past 20 years. They reinvented themselves after the Berlin Wall came down, and they have become a very important anchor in a market economy. There is some value in being new, as well as some value in being several hundred years old. They have had to stop and think how to get multilateral pricing. I am also finding this in a lot of the Islamic countries with their discovery of a regulated market place in their social context. Making sure that shareholders and citizens have some form of savings leads to effective social participation. In this context, I am thinking about Saudi Arabia, Turkey, Morocco, and Egypt, before and during the revolution, and making sure people feel that they are a part of their society. Different uses of the exchange model in different social contexts demonstrate that this is a very diverse world.