Our financial markets could not be riper for disruption than they are right now. Yet beyond dubious initiatives in mortgage and other consumer lending, not much disruption has taken place. Recent innovation has focused on new stock exchanges. The financial markets are being flooded with both new broker-dealer owned trading platforms and new exchanges.
What markets need are new financial instruments that are friendly to traders seeking generic risk management instruments. The introduction of instruments appropriate to the needs of the buy-side and other professional risk managers will open trading in the markets for these instruments that the existing inefficient national market system (NMS) cannot undermine as it does with the instruments listed on the current securities exchanges.
New exchanges will have more promise if they seek to add value to financial instrument trading. To date, some new exchanges have been idealists [IEX, Long Term Stock Exchange (LTSE)] seeking to prevent various exchange-management-perceived abusive trades. Turning away eager market users of exchange services is not the road to success for a new exchange.
Other new exchanges are created simply to compete with the incumbent exchanges for SEC-protected fee income (MEMX and MIAX). There is no way, within the NMS, to discourage new exchanges from applying to the SEC, since exchange fees are generated by broker-dealer adherence to the NMS regs regardless of the volume of transactions within the new exchange itself. But nobody thinks that this is innovation.
An implication of NMS’s negative effect on incumbent exchange incentives is that a disrupter would seek to avoid the burden of NMS. To capture the value of market-wide beneficial disruption, the innovator might offer securities of its own creation. Such securities would not be victimized by NMS-created games – examples of NMS-created glitches include internalized retail market orders and steep colocation fees – since these revenues are all based on abusive use of the securities information processor (SIP). SIP has no adverse effect on a security that is unique to a single exchange.
Where in financial markets is disruption needed most?
In the debt markets particularly, market structure problems are many, and real solutions, few. One thorny problem is a ready means of trading a short hedge of a long-term bond position for users that defer recognition of their fixed-income assets and liabilities.
The currently available solutions are short positions in derivatives such as Treasury note futures and OTC interest rate swaps. The Treasury note futures are marked to market which produces messy accounting problems for financial institutions that defer income and expense recognition.
OTC interest rate swaps have balance sheet-friendly accounting treatment but are also problematic. Elsewhere – here, here, here, and here, for example – I describe the many valuation and credit risk issues endemic to interest rate swaps.
Innovation by the creation of a new financial instrument
This article provides an example of potentially disruptive innovation. It proposes an alternative to the two standard short derivatives hedges. This example illustration is far from the only example of a key to successful market disruption. There are opportunities in every nook and cranny of our financial markets. But innovation in financial markets is a question of invasion of a well-defended fortress. There are plenty of financial market shortcomings, but each one is jealously guarded by financial professionals making a fine living out of doing nothing of value. Any change will be resisted. Best to choose an innovation that will fill a gaping hole in the market system.
Behind the choice of example lies my conviction that coming innovations will be more trader-friendly financial instruments. Following Island’s electronification of stock market trading, most innovation in financial markets has amounted to the clever design of trading algorithms that exploit the latency endemic to the confluence of computer-based algorithm-driven trades with NMS rules.
The opportunity for a contribution to market structure now will be made by introducing instruments that centralize trading, thereby frustrating latency-driven forms of arbitrage profit.
What has failed?
Cryptocurrencies. Specifically Facebook, with its failed introduction of Libra – a planned substitute for the current incredibly inefficient Rube Goldberg machine we laughingly call an international payments system – showed the world why the seemingly perfectly poised GAFA (Google (NASDAQ:GOOGL)(NASDAQ:GOOG), Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN)) disrupters are not so perfectly poised.
Consider Facebook’s Libra. It would have been difficult for Facebook to overcome resistance to such a change in the payments system from a well-prepared, diligent, attack on the status quo. Libra was neither well-considered nor diligently prepared for market introduction, discussed here, here, and here. If GAFA wants a place at the big kids’ table in finance, it needs better regulatory relations – possible only through a vibrant pre-announcement dialog between the innovating firm and the relevant market regulators.
The introduction of cryptocurrencies into the lexicon of finance notwithstanding, bitcoin and other cryptocurrencies have proven to be a dead-end. Despite the failure of Libra, central banks continue their obsession with the potential problems and opportunities cryptocurrencies promise for themselves – particularly among central banks harboring jealousy about the dollar’s international reserve currency status.
New stock exchanges. There is no shortage of new entrants into the suck-the-blood-of-traders feeding frenzy led by the big incumbent exchanges (NYSE, NASDAQ, and CBOE) – the universe of stock exchanges.
Recent entrants come in two flavors. One variety of new exchange – exemplified by IEX and LTSE (Long Term Stock Exchange) – are exchanges formed to discourage one or another prominent class of traders from using them. IEX wishes to stop high-frequency trader opportunism; LTSE, to stop short-termism.
I have racked my brain trying to remember an example of a new business formed to exclude an important class of customers. Men’s clubs in days of yore come to mind, but the strategy has not been a font of excess profitability and seems to be failing in the creation of new exchanges as well.
What would Adam Smith suggest?
Adam Smith and his progeny would tell us the best innovations occur in lightly regulated environments, where entrepreneurial spirits are free to roam. If ever an environment was the antithesis of that ideal environment, it is the market for short term debt that LIBOR once ruled.
Yet the financial market least served by a summary exemplar like index stock ETFs is the market for debt. The markets for short- and long-term debt are notoriously illiquid. Yet issuance of these instruments exceeds that of equities.
Barriers to debt market innovation. Thinking about ways to move quickly to disrupt the financial institution and market space, the eye is attracted to debt markets. This market is fallow ground. Major broker-dealers have established alternative trading systems (ATS) and multilateral trading facilities (MTF) in the US and Europe, but these trading facilities have not, as yet, produced a dominant position in relation to the SEC- and CFTC-regulated exchanges in the US.
A new financial instrument. EOI-short positions
It’s instrument technology, not market technology that has an open field of play. My previous discussions of new exchanges have proposed the introduction of exchange-originated instruments (EOIs), see here. One of the failings of another innovation that I had the good luck to work on, Eurodollar futures, was that like T-note futures the mark-to-market in cash daily of Eurodollar futures is inconsistent with the needs of financial hedgers that defer recognition of income and expenses.
This unattractive property of Eurodollar futures drove me later to promote the use of interest rate swaps – that solve the accounting problem futures presents. But then I encountered the valuation issues and systemic credit risk concerns of interest rate swaps. Swaps solve an accounting problem by introducing multiple real market risk problems. Not a great idea.
All this sent me back to the drawing board. The result is a vehicle that solves market-to-market, market completeness, and accounting issues, the EOI.
The EOI was intended to create an instrument that solves the problem of Eurodollar futures – the market’s dependence on the cash London wholesale deposit market (LIBOR), over which CME has no control. The independence of LIBOR cash from Eurodollar futures has produced the worst imaginable outcome – the LIBOR cash market has dried up, forcing the CME Group (CME) which lists Eurodollar futures to replace the final settlement of each contract with a settlement based on the secured overnight financing rate (SOFR) computed by the Federal Reserve on a daily basis.
The EOI would also present an attractive alternative to a long position in the credit market because it issues an exchange-originated fixed income instrument at settlement. Short squeezes that occur for even the most liquid cash debt are impossible with these exchange-originated instruments. Buyer of an EOI would have no responsibility other than purchase. No margin pays and calls required.
What is missing from the complete replacement of the functioning of the interest rate swap market is a short position in a fixed income instrument that is not marked to market in cash daily. But the exchange could help itself and short traders simultaneously. The exchange could reduce the need to adjust the daily payments between short and the exchange, by offering sellers the right to deliver an initial margin-protected commitment to make buyer’s accrued interest payments – in other words, a sold EOI with margin flowing from EOI supporting instruments moved to seller’s margin account, to be replaced by sellers choice of backing assets from an exchange-approved list at sellers discretion.
Since EOIs exist only with the backing of exchange EOI margin portfolios, there are none of the daisy-chain collateral rehypothecation problems created by ordinary repo and other collateralized debt agreements with this answer to a market for short positions in fixed income that have deferral accounting treatment.
Coincidently Gary Gensler, an expert on the problems of the repo market, has been chosen to head President-elect Biden’s financial market and regulatory transition team. His expertise might smooth the process of introducing such new financial instruments.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.