U.S. FINANCIAL MARKETS: BOTH LAGGARDS AND TRENDSETTERS

Senthil Radhakrishnan, VP Capital Market Solutions, Virtusa

Rakesh Jangili Senior Consultant in Capital Markets Solutions, Virtusa

U.S. capital markets typically define how the rest of the world markets operate; more financial investments are made in the U.S. than in any other country. But this supremacy hasn’t always translated to leading business and technology practices. There are situations where U.S. markets are lagging behind or have operated with known issues, and it’s important to understand where the pitfalls are/were:

• Decimalisation of stocks – Unlike other markets, U.S. stocks were quoted in fractions (e.g. price of stock XYU is $4 1/16 instead of $4.18) instead of decimals until 2001.  A quote in fractions results in market inefficiency, higher costs and price manipulation.
• Quote driven exchanges – Most exchanges in the world moved to order driven exchanges in the nineties; while U.S. exchanges moved to hybrid exchanges which are both quote and order driven only in the last 10 years. In an order driven exchange, a computer matches “buy” and “sell” orders making it efficient and transparent, though it has a downside of not matching low liquidity stock orders.
• Fixed income trading – Fixed income trading in the U.S. is still dominated by voice/fax or mail which leads to higher price spreads and less transparency. In the world of the Internet with well-connected marketplaces, it is propitious to have trading done on an electronic platform in an automated and efficient manner.
• Listed derivatives trading – In listed derivatives trading there is still an unresolved risk in the system as clients could be crossing their limits while trading through an executing broker
• Settlement period – In the U.S. the settlement period for equities is three days after the trade date. This extended period doesn’t have a strong technical or functional rationale.

In an academic article, Christie and Schultz (1994) observed that during 1991 more than 85% of NASDAQ dealers quoted even-eighth while odd-eighth quotes were hardly used in 70% of the stocks. The study was followed by several civil antitrust lawsuits eventually settled for $1.027 billion because of implicit collusion. The change to decimalisation happened years later.

Longer settlement cycles of equities give traders more time to arrange for funds after the trade, resulting in more trading and leverage. This leverage resulted in more counter party credit risk and higher overall risk to the system. The plan to reduce settlement cycles in the U.S. is still under discussion.

While the U.S. has lagged behind in certain areas, it has also been a trendsetter in many areas, including regulations. Here are a few examples.

• Equities trading – U.S. exchanges and brokers have been ahead with features like Algo and program trading, alternative venues like dark pools, ECNS and best-price rule. This has made U.S. markets competitive with one of the lowest commission fees.
• New products – The U.S. was the first to offer new instruments like credit derivatives (started in 1993) for trading; many new order types were also pioneered by US exchanges.
• OTC trading/SEFs – The Dodd Frank rule brought significant changes in OTC trading. The U.S. is the first to introduce SEFs (Swap Execution Facility) or trading venues for OTC contracts and the ecosystem around it which includes credit hubs and clearing houses.
• Derivatives risk calculation – The U.S. has been leaders in derivatives risk calculation models (VAR calculations were introduced in 1990) and in pricing, greatly enhancing financial markets.

The bottom line is that U.S. financial markets seem to lag behind in some areas, but are forging the path forward in others. If one can build sophisticated ecosystems to support low-latency and high frequency trading, is moving to a T+1 trade cycle that difficult (Asia and Europe have it)? The U.S.’ strength has always been its ability to quickly adapt and adopt best practices from rest of the world – a similar approach to financial markets could make a big difference.