In the end, it's the little guy who matters

Jeremy Warner On why the stock exchange needs to look after the retail investor and the death of the Asian model
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The Independent Online
The Stock Exchange's new order- driven trading system continues to amaze with its ability to distort share prices and disadvantage small investors. The FTSE 100 index has been yo yoing around all week, erratically and randomly moving this way and that. To the outside observer, there's little way of telling what's real and what isn't. If the exchange cannot provide an ordered and transparent market place for share trading, what purpose does it have?

So serious have the problems become that a series of changes have been introduced to prevent the market being distorted on New Year's Eve, traditionally a thin day for trading, but an all important one because the closing index of the year is widely used for valuation purposes by organisations and institutional investors.

The most important of these changes is that for this one day the exchange will suspend the normal rules of the market place and assess the closing index itself, by throwing out prices it regards as anomalous. This is as close to an admission of failure as it is possible to get without being explicit about it. If the closing price of a market is determined not by the market but by an independent adjudicator, then by definition it is no longer a market. If on the other hand the independent adjudicator's guess at the "real" level of the market is a more reliable one than the trading system generates, then plainly the system has failed.

Technically, Sets has been a great success, having crashed only once since its launch on 20 October. But practically it has been a disaster, with very little by way of mitigation. It is no wonder many are giving up on the new system (Sets only accounts for 40 per cent of trades in the stocks it covers), preferring instead to deal either directly with market makers or to use the old quote driven system; the prices just aren't reliable.

The main problem is with so called "rogue trades", which generally happen first thing in the morning or at the end of the day when there is not much activity. What activity there is often takes place at unrepresentative prices, which in turn distorts the opening or closing level. As a consequence the FTSE 100 has since the new system was launched been subject to wild gyrations not at all reflective of what is really happening in the market.

Sometimes, as appears to have happened a few weeks ago with some late trading in pharmaceutical stocks by JP Morgan, this is done with the deliberate intention of distorting the market, presumably because of a matching futures or options position. But most of the time the distortion is random and of innocent intent. A rogue price is entered, more in hope than anticipation, and some fool picks it up.

Unfortunately, the effect is far from innocent. Many will trust these prices as a basis for making an investment decision. Worse, those who instruct their broker to deal at the best available price (a not unreasonable way of proceeding) could and do find themselves dealing at the rogue prices, since these might be the only ones available at the time.

As always, it is the investors least capable of looking after their own interests - generally small retail investors - that tend to get the most disadvantaged. Without a real handle on what's going on in the market, your chances of losing money are that much higher under the new system than the old. It scarcely needs saying that a market which favours the insider over the outsider is an imperfect and potentially corrupt one.

It is hard to know what can be done to solve these problems. So much has been invested in the new system, both in terms of money and ego, that there is no question of abandoning it and going fully back to the old. It is also important to bear in mind that this new trading system is actually what the big users of the stock market - institutional investors - wanted and lobbied for. Without going over to an order driven system, it was often said when the debate was raging, there was a real risk of London losing out to the computer based systems of France and Frankfurt. It was a question of modernise, or die, the Stock Exchange executive would insist.

But was it really right to copy the Continental bourses? The order driven system seems to have worked well in France and Frankfurt, but these are small exchanges by comparison with London, and the degree to which they need to cater for the retail investor is smaller still. Big institutional investors can usually look after their own interests. For some of them, it is questionable that they need an exchange at all. The new system is being used by many as just a sounding board for a growing level of offmarket trading. That in turn is squeezing another category of share trader, the agency broker.

Curiously, the market which the Stock Exchange's old quote driven system bears most resemblance to is Nasdaq, "the market for the 21st century", as it calls itself in its TV advertisements. How odd that a system the stock exchange seems to regard as old fashioned and out of date is the one that attracts the world's best high technology growth stocks and is the most important rival in the US to the New York stock exchange. How odd too that Nasdaq specifically targets the retail investor as the one it is in business to serve. Somewhere along the line, our own Stock Exchange seems to have lost the plot.

For those of us who believe in the free market, the most satisfying thing about the crisis in Korea and elsewhere in the Pacific Rim is the way it has vindicated the short termist, non interventionist approach of Wall Street and the City. For many years now, it has been fashionable to look longingly at the example of Japan, her clones in the Far East, and other examples of communitarian capitalism and ask, "why don't we do it like that"?

The answer is now apparent; the long term relationships built up in these economies between bankers, investors, companies and governments, far from yielding a competitive advantage, has actually led to some extremely poor investment decisions, to a molly coddling of unnecessary and uneconomic companies and projects.

So concentrated on the long term have some of these countries become that they seem to have lost all sight of the need for short term profit and plain good housekeeping. These very close between partnerships between industry, finance and government, seem to have resulted less in the long term good and more, as we now know, in uncommercial favouritism and misallocation of capital. Our own arms length, Anglo Saxon capitalist ways may have their drawbacks, but at least we don't build uneconomic car plants (unless we are bribing the Japanese and the Koreans to do it for us, ofcourse, with large amounts of state aid).

The lesson for Tony Blair and New Labour of what's happened in the Far East is an uncomfortable one - that there may be no middle way between the American model with its often brutal social consequences, and old style socialist ideals. Certainly we are unlikely to be hearing for some time of the role model attributes of Asia.

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