Picking Pockets in the Dark

The recent move towards transparency and disclosure in financial markets is not before time. The unmasking of nefarious conduct by market participants, which seems to be a regular event, has increased the level of distrust in financial markets with each incident. Governments, prosecutors, and regulators are now at least taking steps to try and address the situation. There is activity in interest rate, foreign exchange, and bond markets in multiple countries. And the UK government called for “full transparency of all costs and charges throughout the value chain” in March 2014, specifically targeting those at work in the defined contribution industry.

I am conscious that there are significant costs and operational hurdles to move from a spread-only environment to one of explicit trade prices and defined transaction costs.

And yet, moves towards greater transparency, in the context of transaction costs, are fundamentally undermined by “spread-only” trades, a common approach for transacting many financial instruments. Spread-only trades have no explicit transaction costs and/or commissions; dealers earn their “fee” based on the difference between what they pay (bid) and what they sell at (offer). The approach is common in over-the-counter markets, particularly bonds and foreign exchange. (There is a bid/offer spread for exchange-traded instruments, such as equities, but here the dealer earns an explicit commission and the trade is concluded at an agreed and transparent price.)

Any effort to try to measure transaction costs is largely meaningless in the presence of spread-only trades, as this approach makes it impossible to determine whether:

• the level at which the trade was executed was competitive

• the bid/offer spread represented fair compensation to the market maker for providing liquidity to the market

• the costs of execution were reasonable

• any other costs were swept into the trade

Explicitly capturing each of these elements (and others that I have not listed) creates a more informed and hopefully efficient and effective market place, likely to better serve its end users—if not its insiders, as has often been the case. Participants can choose who they deal with based on their capability and the value they provide. Market forces will likely drive costs down and eliminate unnecessary cost elements. Explicit transaction costs and clear trade prices will also support the type of transparency many in positions of authority are striving for.

I am conscious that there are significant costs and operational hurdles to move from a spread-only environment to one of explicit trade prices and defined transaction costs. The change would be a massive undertaking, albeit one for which precedent exists (e.g. the equity market). The change would also, ideally, be undertaken on a globally coordinated basis in order to avoid compliant regimes being disadvantaged relative to those operating under old rules. There is no reason why a phased approach, over a number of years with a clear timetable, could not work.

I also expect significant resistance to a proposed end to spread-only trades—not least from those who take a tidy turn from their activities in these markets. However, the interests of these few (by number, if not by voice and lobbying budget) need to be weighed up against the interests of the global legion of savers and institutions whose capital flows through these markets. These savers’ efforts to provide for their needs—rather than rely on the increasingly overstretched state—are undermined by the actions of market participants picking investors’ pockets in the dark. Institutions seeking to efficiently run their financial operations are being hampered by information denied them. Regulators need to intervene, as markets have repeatedly failed savers and institutions.

Former US Supreme Court Justice Louis Brandeis famously said, “sunlight is the best disinfectant.” Let’s bring the details of trading all instruments out into the open. The UK would be a natural catalyst for the process of eliminating spread-only trades given the drive for transparency already under way in the pensions market. Other countries with compulsory savings systems and/or sovereign wealth funds have a natural interest in the issue, too. Ultimately, all regulators that seek to create level playing fields in the markets they supervise will have to tackle the issue. A concerted and coordinated approach will lead to the gap being narrowed and smoother progress towards better outcomes for society being made. Why allow the status quo to persist?

—Ralph Frank is CEO at Charlton Frank and has 20 years of experience advising on and managing pension fund assets.