Linking bourses from all over the world could cause a financial crash worse than ever before, warn Alex Brummer and Jill Treanor
The next stock market crash could be so sudden and so devastating that it would dwarf those of October 1929 and 1987, and all the policy makers and regulators in the world will find it impossible to stem the disaster.
That could be the ultimate consequence of the trend among international stock markets, bourses and futures and options exchanges for forging alliances and merging trading systems.
The global nature of financial markets was evident in 1987 when panic selling in New York spread to the Pacific and Europe and then back to Wall Street in a horrifying 48 hours during which policy-makers struggled to restore confidence.
Next time it could be even worse: the decade since 1987 has seen enormous changes in global equity markets. Popular capitalism and shareholding has become more commonplace from the mid-western United States to middle Europe and in dozens of emerging markets around the world, from Brazil to Zimbabwe.
The upsurge in equity investment has been accompanied by tens of thousands of new products, like derivatives built on stock market indices, which are intended to hedge against losses but have made markets far more volatile.
And the advance of technology has created screen-based systems which allow dealers in London, or even individuals on the Internet, to buy stocks across the globe on the click of a mouse, or with a single key stroke.
The move towards a single global stock market in the world’s top companies is being driven by several factors. There is a demand by an increasing number of global investors for a better geographical spread in their portfolios. Fund managers scour the globe for opportunities.
But the need for armies of skilled analysts is enormous. It would be far cheaper if they could find a defined basket of global shares, which could be tracked by computers, where the decisions are made automatically.
That cuts out the need for the support staff and, if the stocks are represented by a definable index, opens the possibility of hedging against currency changes, interest rate switches or even a rise and fall in the underlying portfolio by buying contracts on the next movement in the index on the future and options markets.
A second driver towards a more universal stock market, in Europe in particular, is the arrival of the single European currency – the euro – on January 1 1999.
At a stroke, shares and bonds quoted within the euro area of 11 countries will be priced in a common currency, in much the same way as shares quoted in New York and on North America’s West Coast markets.
Thus the valuation placed on a bank quoted on the Dublin stock market will be compared with one on the Deutsche Brse in Frankfurt. Fund managers and investors will increasingly think in terms of sectors instead of countries – the European banking or technology sector instead of Spain or Luxembourg.
The inevitable consequence of this and the development of the euro as a reserve currency, in which second or third countries hold their reserves or investments, has been for European markets to come together.
Earlier this month, two competitors in the old Europe, the London Stock Exchange and the Deutsche Brse, announced to an astonished financial community that they were to form a strategic alliance under which Europe’s top 300 to 400 companies would be together on a common trading platform – a sort of European super- league to take on the Big Board in New York.
The London-Frankfurt alliance, which is founded on a certain belief that the euro will be a success, is just one of dozens of such strategic deals which could eventually result in a single global market.
Nasdaq, the US screen-based market on which such new-wave shares as Microsoft and Intel (two of the US’s biggest companies) are traded, has recently absorbed the American Stock Exchange, which operates a traditional open-outcry system – where people, not machines, match the orders.
Similarly, the American Stock Exchange itself has recently absorbed an East Coast rival, the Philadelphia. The inevitable outcome of such mergers is that the cheaper and more efficient electronic-based systems eventually triumph.
Having expanded in the US, where it now provides a significant challenge to the world’s richest bourse, the New York Stock Exchange, Nasdaq is looking for new challenges in Europe. It has held preliminary talks with the Frankfurt exchange, been to Paris and also tried to cut deals in London.
Elsewhere in the US, the Pacific Exchange based in San Francisco – which in recent years has increasingly looked towards Asia – has also been joining the rush to amalgamation. As a first step, it has agreed to join the Chicago Board Options Exchange, the world’s biggest options market, which specialises in complex derivative products. The two groups are working out the details, including whether it will be possible to operate a common trading platform, one of the issues which is still to be settled between London and Frankfurt.
Meanwhile, other European countries like Austria are queuing up to become extra partners in the London-Frankfurt alliance while Paris seeks to align itself with Spain. But the odds are that eventually the sheer size of the quoted sectors in London and Frankfurt will mean that this becomes the dominant electronic trading system for the new Europe and the stepping stone to even more global alliances.
Getting a more global trading system right is one of the toughest challenges all the exchanges face. London has had a troublesome experience with its technology. The stock exchange wasted 400-million developing Taurus, a paperless system which never worked. It was eventually replaced by Crest, itself dogged by teething problems and initially unpopular with its users.
The London Stock Exchange then spent another 80-million or so introducing Sets, an electronic system which radically alters the way shares change hands.
While new technology tends to attract controversy, London’s futures and options exchange, Liffe, is feeling the pain of being too slow to embrace it. Liffe – the London International Financial Futures and Options Exchange – has suffered the humiliation of losing one of its main contracts to the DTB, a rival, electronic exchange in Germany, because it failed to understand the speed and cost savings associated with trading by computer screen.
Next week Liffe will dump its old method of trading entirely for some of its contracts. The young people in colourful jackets doing deals with one another, using hand signals to make themselves understood above the noise of the trading floor, have faced up to change. The exhilaration of battling for the best position in trading “pits” will be replaced by endless hours of watching prices move on a computer screen.
Without those screens, the idea of a single global exchange would be impossible. The trading floors of Liffe in London and the derivatives exchanges in Chicago are enormous, the size of numerous football pitches joined together. To put them all in one location would be impossible, but the technology to develop a global exchange is available.
Datastream/ICV, an information provider which is also developing Liffe’s new trading system, collects data from 140 exchanges around the world and can display the prices on one screen.
It is not quite a “global” exchange, but it is a “global” view of the prices at which shares are changing hands. Robert Rivero, head of product development at Datastream/ICV, said: “People like me will make it look like one exchange.” He is working on technology which will make the current trading systems used by exchanges compatible with one another.
The “global” exchange need not be a single exchange. It might turn out to be a number of exchanges, specialising in certain stocks, such as pharmaceuticals, all connected to each other by a common platform.
Rivero paints a picture of a dealer looking at the array of prices displayed on a single computer screen. Elf, the giant French oil company, will be listed side-by-side with British Petroleum (BP), for instance. When the dealer clicks on Elf, the order will be routed through to the exchange it is listed on, say the Paris Bourse, while the order for BP will be routed through to London.
For the giant investment banks, themselves in the throes of merging with one another, the implications are that they will no longer need teams of dealers spread around financial centres.
It could be good news for London, where many international banks are already basing their European hubs. Equally, however, international bankers could base themselves in the Bahamas, in Luton or even in their own bedrooms, provided they could receive the information they required.
The prospective global stock market poses serious problems for regulators.
Patrolling the emerging Internet market in personal financial transactions is already an issue which has troubled global leaders and was raised at the May Group of Eight summit in Birmingham.
Regulators are fiercely jealous of their turf. In the US the two most powerful economic figures, the chair of the Federal Reserve, Alan Greenspan, and the Treasury Secretary, Robert Rubin, are already in a public battle in Congress over supervision of superbanks which are involved in commercial, investment and insurance activities.
Similarly, the Securities Exchange Commission – which has patrolled share markets since the 1930s – is coming up against the ambitious Commodity Futures Trading Commission, which supervises futures and options markets and believes it should have a strong role now that the lines between shares and futures markets are more blurred.
Similar power struggles can be expected among national authorities as trans-border link-ups multiply.
Unless a sufficiently robust system of enforcement and regulation can be established, the chances of bringing any order to the chaos when global markets crash will be even smaller than now.