The Economics Of Market Surveillance

In today’s world, before one can address the regulatory or moral issues of surveillance, it is realistic to suggest that one has to address the economics for surveillance.

Market venues find themselves in a highly competitive cut throat price war where there is a race to the bottom on trading tariffs. Therefore all their attention is on developing or retaining the secondary trading business and current strategies are threefold:

• cut costs and develop other complementary businesses e.g. clearing and settlement, data centre services, market data or whatever;

• develop economies of scale in the core trading business by attracting or acquiring liquidity as a direct benefit of cost cutting, innovation in the underlying trading services and / or acquiring competing venues (the latest examples being Nyfix Euromillennium in the case of NYSE Euronext, Turquoise in the case of the LSE, preceded by a number in North America to prevent the demise of NASDAQ and NYSE); and

• minimise the expenditure on fringe activities - and currently for venues, surveillance increasingly falls into this category.

Cutting costs per se may be a necessary short term solution particularly for non-performing functions. However, it is not a long term success factor as the net result on earnings for a venue may be nil as it is likely that cost cutting will be matched by tariff reductions. This is particularly true of the fight to attract or retain new liquidity in the form of high frequency trading (HFT) – HFT has little venue loyalty, not even as long as it takes to do a double click. Cost cutting is essential for incumbent markets as they are expensive compared to new entrants. In the case of NYSE Euronext in Europe it is estimated that each trade costs an extra 4.5 basis points compared to an optimal best execution price discovery venues for the most liquid European securities (based on Equiduct data in Sept 09). Other venues have different levels of in built inefficiencies – both higher and lower.

For longer term success, markets need to compete on market quality, providing higher levels of market surveillance with a greater probability of market abuse detection. If markets compete on market quality, in the long term this is likely to attract buy side interest as they can choose where they direct their order flow. Many buy side organisations today in Europe believe they do not consistently receive best execution, but they cannot prove it. They also cannot prove whether their order flow is manipulated by market abuse activity, though many suspect it is.

The challenge, however, is how can venues compete on market quality and implement modern surveillance solutions without substantially increasing their expenditure? If the regulators or the venues do not want to compete on market quality, then the buy side need to organise themselves to demand market quality metrics for each trade and the content of order books.

All things being equal - and after a race to the bottom on tariffs and latency - they will indeed tend to be equal among the surviving venues, what is left to compete on other than the integrity of the venues? Why would a buy-side player direct his business to a venue that could not demonstrate its integrity compared to one that can. So the question venues who want to thrive ought to be asking is not how little can I get away with spending on surveillance, to satisfy my regulator, but how can I arrange that surveillance is done to the best possible standard in the most cost-effective way?

In future blogs we will discuss the ideas we in the AVENUES Alliance have been developing to answer this question.