Effects of Disruption: Financial Innovation and Market Integrity

Francesco Guerrera

Innovation has been a mixed bag for investors, according to an expert panel convened today at the 65th CFA Institute Annual Conference in Chicago. While markets have become more efficient in many respects, with trading intermediaries whittled down and automated, threats to market integrity remain, including a reliance on leverage to squeeze profit margins from new banking business models and continued opacity in the darker shadows of the marketplace.

Francesco Guerrera of the Wall Street Journal moderated the panel, which included Bill Hambrecht, CEO of W.R. Hambrecht and Co; Duncan Niederauer, CEO of NYSE/Euronext; and Harold Bradley, chief investment officer of the Ewing Marion Kaufmann Foundation. Taken together, the panel represented perspectives of the triumvirate of sell side, buy side, and exchanges that make the capital markets work.

Perhaps surprisingly, the panelists were quick to praise the benefits of technology and caution against ascribing all of the market’s ills to the withering of high-touch open outcry trading systems. Hambrecht noted that retail investors in particular get a good deal as the days of big markups fade in the light of more readily available information and automated trading. After all, as Bradley pointed out, spreads have tightened dramatically in the last decade, which has been almost uniformly good for investors. But the pressures that tighter spreads have put on dealers have created incentives for more reliance on proprietary risk-taking, which continues to pose systemic risks and can upend the entire system to the detriment of all.

The panel for "Challenging Industry Norms" (from left to right): Duncan L. Niederauer, Bill Hambrecht, Harold S. Bradley, and Francesco Guerrera.

The panel for "Challenging Industry Norms" (from left to right): Duncan L. Niederauer, Bill Hambrecht, Harold S. Bradley, and Francesco Guerrera.

Niederauer seized on the discussion of risks to note that the notion of “100 year floods” is hopelessly outdated and that investors and regulators alike need to adapt to the reality of large disruptive events far more frequently, perhaps every five to seven years. In his words, “regulators aren’t smart enough to have firehouses placed correctly,” so the correct regulatory strategy should be to develop effective responses to bubbles and crises as they develop rather than try to anticipate every problem and control it.

The panelists also debated the notion of lowering the standards required to access public capital markets for smaller and medium-sized enterprises, focusing on the recently enacted JOBS Act in the United States. By that legislation, some small firms are exempt from the protective requirements imposed by Sarbanes-Oxley, which Hambrecht described as a “terrible psychological barrier” to emerging companies that is less oppressive in reality. Niederauer took the position that Sarbanes-Oxley wasn’t effective in fulfilling its intended purpose to safeguard investors and that in any event, investors could easily choose not to invest in companies that didn’t comply with SarbOx if they felt that was a critical failing. Bradley added that smaller emerging companies rarely have complex financial structures, thus reducing the opacity and complexity that create some of the conditions that are ripe for fraud.

Guerrera closed the discussion by asking for overall impressions of the effects of innovation on the market. The three panelists agreed that technology has introduced many efficiencies and in some respects has democratized the investor process by facilitating the flow of information in the market. But caution was advised on several fronts, including the continued growth of so-called “dark” markets where the benefits of transparency are eliminated; the continued mammoth scale of derivative exposures to banks and commensurate counterparty risks; and the use of leverage in a low-rate environment to juice up returns.

The CFA Institute “Challenging Industry Norms” series examines widely held beliefs and practices in capital markets and challenges them with fresh perspectives and lively debates. Listen to past events in this series here.

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