Has the Big Bang sputtered to a fizzle?
Twenty-five years after the so-called Big Bang cleared the way for an era of greater securities market competition and efficiency, experienced market participants fear that the industry’s innovative spark is danger of being extinguished.
The ‘Big Bang’ deregulation of the London Stock Exchange, which took effect on 27 October, 1986, saw sweeping changes, including the elimination of fixed commission charges, the introduction of screen-based trading and the abolition of the distinction between jobbers – firms acting as market makers – and stockbrokers. Overnight, the clubby atmosphere of the City dissipated as the oak doors creaked open to foreigners and commoners alike. US and European institutions snapped up partner-owned merchant banks and newly amalgamated broker-dealer firms as lower trading costs gave the British middle class the incentives to invest more of their savings in equities.
While in 1986 the Big Bang was about ridding the industry of fixed costs and growing volumes, today the European Commission is proposing a blanket financial transaction tax which could severely limit stock market activity. As the Big Bang led to the birth of innovation in electronic trading, new rules contained in the second iteration of Europe’s Markets in Financial Instruments Directive (MiFID II) could cramp innovation by placing restrictions on algorithms and high-frequency trading (HFT).
Bang on the money
A complement to the UK’s extensive 1980s privatisation programme, the Big Bang prompted greater competition for investor order flow and created the capacity for handling substantially higher turnover. To this extent, it was a key plank of the Conservative government’s overhaul of the UK economy. But the move from floor to screen also had global significance, because it heralded greater market access for international and local investors alike to a hitherto closed shop.
Richard Balarkas, chief executive of agency broker Instinet Europe, sees the Big Bang as the birth of a democratisation process that has stalled in recent years.
“When I first got involved in direct equity ownership during the government privatisations of the 1980s and wanted to sell my shares in British Gas, I could not understand why I had to struggle to find a stockbroker to accept my order and then hand over 50% of my gains for the privilege,” said Balarkas. “I thought it unreasonable I couldn’t find a better broker service but was excluded from selling them myself. Until British entrepreneur David Jones set up over-the-phone share business Sharelink in 1987 and revolutionised retail broking, you couldn’t telephone a broker or get an execution-only service.”
To Balarkas, Big Bang – which also transformed exchange membership criteria – was crucial both to greater stock market participation by investors and the fortunes of the London as a financial centre. Even the recent trends such as market fragmentation and HFT can trace direct lineage to 1986.
“In the last 25 years, we have seen an absolute switch from the domination of supplier power, in the form of the exchange and its members, to the domination of buyer power today in the form of high-frequency traders. Just look at how exchanges are falling over themselves to provide better services and lower charges to trading firms. Now it is the buyer who is dominant,” he said.
But a highly politicised atmosphere since the global financial crisis has seen regulation swing from a pro-competition to an ultra-cautious stance.
“Take the MiFID II mood music about HFT and algorithmic trading,” he said. “One could be mistaken for believing they were the root cause of the financial crisis, not the US sub-prime market and over-leveraging. Despite the absence of any empirical justification, it seems inevitable these activities will feel the burden of increased regulation.
“In the present environment, some politicians appear to see trading as a necessary evil that must be endured for investment to take place, but ideally the shares bought should be for the long term and not sold until you take your pension forty years later,” he said.
Rather than turn back the clock, Balarkas believes regulators should finish the job started in 1986 by enabling complete unbundling of commissions, so that research commitments are not the deciding factor in the selection of execution services.
“This was the way the Big Bang was originally headed but we are not yet there. Much of the current regulatory debate around risk and market infrastructure becomes irrelevant if large investors are still directing trades and commission to pay for research and corporate access. Competition issues need to be dealt with at the same time as market structure.”
Start with a bang
Steve Wood, founder of Global Buy Side Trading Consultants, was dealing for JP Morgan Asset Management in 1986, trading equities, fixed income, FX and derivatives.
“The exchange literally closed overnight and the next trading day electronic trading was born,” said Wood. “For buy-siders, transparency in the trade and speed of execution was a great benefit.”
While Big Bang might have brought about a rapid transformation in 1986, the pace of regulatory change is even faster today, says Wood, who argues that while today’s watchdogs may be focused on limiting specific types of market behaviour, the industry’s capacity for innovation and competition will remain undimmed.
“The regulators are being very mature in their responses to the current environment. They are working to set timeframes and dealing with the problems which caused the global financial crisis. This is an important and essential task and even if the new rules of engagement appear restrictive, the industry will find better ways to do business,” he said.
To Wood, the fast-growing trend towards HFT is a poignant example. “Whatever the regulators do, innovators will design around it and find new ways to electronically trade in high frequencies,” he said.
In 1986, Thomas Jordan, founder and president of securities regulatory consultancy Jordan & Jordan, saw the Big Bang as an opportunity to make inroads into London. Jordan was US chief executive of now defunct market data company Knight Ridder Financial. Throughout the mid-to-late eighties, he worked closely with London-based brokers to assess their data needs pre- and post-Big Bang.
“In the lead-up, one of the main concerns of many participants was the blurring of the lines between dealers and jobbers. Much like today, where distinctions between brokers and exchanges are becoming less clear, many people in 1986 were worried about unintended consequences,” said Jordan, adding that fears were confounded in the event by greater competition, more transparency and fairer prices.
With the forces of competition having held sway for so long, the challenge for securities market participants today is to grow revenues sufficiently to keep up with the mounting costs of regulation designed to curb specific activities, says Jordan.
While Europe contends with a proposed transaction tax and requirements to register algos under MiFID II, the US is coming to terms with the Volcker Rule and new ways of trading OTC derivatives. All measures are designed at least in part to improve the stability of markets in the wake of 2008 crisis. Jordan believes that collecting the data the regulators request can prove costly and does not necessarily help to solve perceived problems.
“Any medium-sized broker-dealer today has more technology than your average financial regulator,” he said. “Regulators cannot afford to take their eye off what this business is really about: the raising of capital and helping other companies grow. We need to work with the regulatory community to ensure that changes encourage and facilitate revenue growth.”
Bigger bang for buck?
Tony Whalley started work in the city in 1978 and by 1986 was head of derivatives sales at broker Scrimgeour Kemp-Gee.
To him, the sudden availability of electronic trading changed the way the industry thought about risk. The upshot for the sell-side was that they believed they had better control over risk and inventory. But rather than decrease risk, Whalley believes the advances led to greater risk taking.
“Because the books were now more central, hedging opportunities became more available and specific risk moved to a different level and was viewed from a new perspective,” he said.
Now investment director at Scottish Widows Investment Partnership, Whalley said the biggest advantage of the Big Bang was increased transparency.
“Before the Big Bang, almost everything was traded on the floor of the exchange and the prices could be variable, because jobbers could and would make different prices to different customers,” he said. “Once prices hit the screen, they were there for everyone to see and jobbers were unable to play the different counterparties off against one another as easily.”
However, with competition and transparency came increased cost for the industry in the form of technology and compliance.
“Before the Big Bang, trading was a relatively low-cost operation,” he said, noting that while Scrimgeour Kemp-Gee was one of the bigger equities players with 250 staff, 80 of those staff were partners and the back office was, compared to today, a relatively small operation. “The birth of electronic trading may have led to greater levels of sophistication in the markets and higher volumes, but it also saw the rapid birth of complexity and an eventual explosion of regulatory obligations,” he said.
By the 30th anniversary of the Big Bang in 2016, the industry will have been reshaped again by further regulatory and technological change. But to Whalley, one thing is absolutely certain: the ‘electronification’ of execution will continue.
“The growth of electronic trading will not be curbed by regulation. Those who choose to take risk using electronic strategies will find new, faster and more innovative ways to take that risk. But how the industry will look in the future is impossible to guess,” he said. “In 1986, no one could have foreseen the course electronic trading would take 25 years on.”
For all its benefits to investors, 1986 also wrought havoc in London’s square mile. Firms that failed to adapt to a new set of risks and rewards were crushed by the march of progress.
“As we see more and more organisations and people on both the buy- and sell-side abdicating the responsibility of decision-making to technology, we will be in danger of losing a very valuable skill set from the market,” said Whalley.