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LSE: Public lectures and events
The way forward: building a sustainable recovery and driving growth
01:09:24
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- [00:00]
Howard Davies
Well, good evening. I think, actually after today's news in the Financial Times, I should be ringing a bell to announce the start of this lecture, since the FT reported this morning that the London Stock Exchange was thinking of copying the NYSE with a bell to open trading. But no doubt Xavier will tell us whether that's true or not, or just a normal piece of FT imaginative writing. But we're delighted to welcome Xavier Rolle here this evening, who's been the CEO of the London Stock Exchange since May of this year. He took over from Clara Furze, who had been there for a number of years. And I'm afraid I have to tell you that he has a particular drawback, really taking over from Clara Furze. And that's not because it's not a sexist observation that I'm making here, but it's that Clara Furze was an LSE alumna, which, sadly, Xavier is not. He was at Columbia Business School where he did his MBA and of course in France before that. Before joining the Stock Exchange, he. He worked for a number of firms in the city. Goldman's Credit Suisse, Dresden, Kleinwalk, Benson and Lehman Brothers, some of which still exist.
- [01:30]
Xavier Rolle
And.
- [01:33]
Howard Davies
Was in fact global head of equity trading at Lehman Brothers for a while, but has taken over at a very interesting time, I think, both, of course, for financial markets generally and the economy generally, but also a particularly interesting time for the future of exchanges and share trading, which is in the throes of a competitive dynamic which is, I think, quite unpredictable. Quite hard to see how the landscape of equity trading will settle down with the introduction of. Of multilateral trading facilities after the MIFID directive. And quite an exciting moment, I think, in the world of equity trading. But you're not here to listen to my thoughts on how that might evolve. You're here to listen to Xavier Holle. So I'm going to hand over straight to him.
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Xavier Rolle
Welcome. Thank you.
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First of all, I would say it is not a bell, not a conventional bell. We will keep the surprise that I've.
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Just said to the BBC.
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Secondly, I'm not yet an LSC alumnus. I don't know how long that would last. But if they do make me an alumnus, maybe I can come here and.
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Take a few courses.
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Would you have me? So it's a pleasure. Good evening to all of you.
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It's a pleasure.
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Pleasure being here to discuss the way forward, building a sustainable recovery and driving growth. That's quite an agenda. I'm very grateful to Howard for his kind introduction and for offering me a.
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Chance to address you tonight here in.
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Such a prestigious environment. It is to the great credit of the LSE University that it holds these public lectures and although I can't match some of your recent speakers for book sales or attractiveness, I hear you had a speech in Spanish last night. Howard convinced me not to give this one in French.
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I will try.
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I hope that my thoughts on this evening's topic will be useful to you. The events of the past two years in the global economy clearly have caused even the most ardent free marketers the.
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Question of, you know, what are the.
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Foundations of capitalism and are they solid? Indeed, friends that I never thought would say such things have questioned the very basis of our economic system, including some.
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Of my friends in the United States.
- [04:16]
Which was mostly shocking to me. Again, I speak as someone who has quite a few friends in this business, having worked in financial markets all over the world for more than 27 years. However, personally, I do not believe that this was a crisis of capitalism, the economy as a whole, or even a crisis of financial services. In my analysis, this was a crisis of excessively leveraged debt, opaque securitization, and frankly, loose monetary policy, with a few regulatory issues coming coming on top. I come to this debate from the view that markets are not, and certainly never have been, flawless. For sure, they are very simply the most efficient mechanism for matching capital to growth. We certainly cannot and have not in the past succeeded at entirely removing crises from the system. Irrational exuberance, to quote one expression, will certainly continue to be part of the market as long as it's part of human nature. However, we can seek to build a sustainable financial framework which is able to better absorb these shocks. That is why I believe we need a new conception of the good economy, one built around sustainable outcomes. And so I would like to use this evening to talk about how we can build systems able to sustain our flawed but precious market economy. I would like to focus on three key areas. First of all, some thoughts on the causes of this crisis. Then what might a new economic segment look like?
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And finally, the steps that will take us there.
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As you might expect from the CEO of Europe's happy to advertise its continuing largest stock exchange. I believe these steps will include a.
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Rediscovery of the benefits of equity funding.
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And also the exchange model, and in particular the model's integral qualities of transparency, neutrality and liquidity. Europe has had a tradition of funding growth through bank lending, frankly, rather than through equity markets, a tradition which has been reflected in bank balance sheets over the years. Policymakers and Central banks have worked to ensure that this lending was economically sustainable. Historically, the preferred method of controlling lending was to introduce controls over interest rates, which clearly can be a blunt instrument and are almost inevitably used too late. In the longer term, we need to build a sustainable, diversified funding ecosystem which reflects a greater role for equity markets as a significant mechanism for raising capital alongside the existing culture of debt finance. This will not be a question of regulation restrictions. Restricting lending will actually create added and unwelcome barriers for business. It will be a question of ensuring that capital markets infrastructure is as efficient as possible in its crucial task of matching investors, companies, entrepreneurs and innovators. We have to work to recognize the important benefits of bringing products on exchange, both in the US and in Europe, but for differing reasons. In the US capital markets are widely used, but not enough has been done on transparent exchanges. In the eu, both transparency and levels of exchange trading are lower than they should be. The current crisis gives us many examples of these problems and is an excellent place to begin.
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This crisis in effect was what we call a double bubble of credit and.
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Asset prices which devastated the wholesale financial markets as a result of the complexity and opacity of securitization and failures in risk evaluation. It grew with what now appears to be inevitability from the combination of suppressed interest rates and low returns on many long term investments. I'd like to draw your attention to what I view as an important historical event. Eleven years ago, a hedge fund called.
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Long Term Capital Management, ltcm, collapsed.
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It is important in any discussion of this crisis, not least because it was the last time a crisis could be solved by the intervention of the other market participants alone. But significantly, the response of US policymakers to the collapse of LTCM was to.
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Offer three sharp cuts in interest rates in total.
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Between 2000 and 2003, the Fed cut interest rates from 6.5 to 1% and they remained low, creating a false sense of permanence in monetary policy. The result was an asset price bubble in housing. As mortgages became far more accessible, the limiting factor swiftly became how many mortgages the originators could afford to offer rather than how many people wanted and could get a mortgage. And just as individuals and corporations were seduced by low interest rates, banks geared themselves up in order to improve return. Every financial crisis since the war, with the exception to a large degree of the dot com boom, has been a variation on this theme. Excessive leverage creates a bubble which is then burst by a rise in interest rates and a collapse in market confidence. Running parallel to this abundance of cheap Debt. The growth of China and the new economies on the strength of exports to the west created trade imbalances in a surplus of dollars which were invested in the safest possible place U.S. treasury bills. The result was a fold in the.
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Yields available to investors.
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Inevitably, in this low yield environment, the more ambitious and enterprising asset managers began to search for alternative investments. They sought the higher returns demanded by a competitive industry in a society whose aging demographics demanded significant returns on investment. These two great oil tankers, the housing price bubble and a wholesale market searching for the next big win crashed into each other through the development of the originate to distribute securitization pipeline. This basic process, which is known as securitization, is an entirely valid means of dispersing risk. But more and more complex and geared products were devised which relied on flawed assumptions and rating agency modeling which suggested that the underlying assets, namely property loans, were basically safe. Mortgage providers were reaching further down the socioeconomic chain, offering greater numbers of subprime loans which became packaged into more risky securities. By 2003, indeed, the number of mortgage applicants rejected had halved to just 14%. And subprime PAC bonds grew into a trillion dollar market. With hindsight of course, we can see that the decision of U.S. regulators in 2004 to lower capital buffers increased further the amount of leverage swelling through the system. This decision meant investment banks could hold 1.6% capital against these investments rather than 8%. That's just $16,000 per million. 2001, three years before this change, Merrill Lynch's leverage, for example leverage ratio was 16 to 1 by 2007. Three years later, it had risen to 32 to 1. Morgan Stanley and Bear Stearns were leveraged even higher at 33 to 1. Care to know? Lehman Brothers was 35. And then suddenly the game changed. The debt fuel bubble burst. In 2006, interest rates rose above 5% here and in the US consumers started to find their mortgages unaffordable. House prices on both sides of the Atlantic fell by over 20%. Defaults grew on a truly astonishing scale. The bank's prized cash cows were certainly worthless. The result was devastation played out daily across the markets. Aig, who were one of the principal insurers in the market, collapsed into the arms of the US taxpayer. Bear Stearns was acquired by JP Morgan and Lehman. Well, we all know what happened there in Iceland. A whole economy built on a financial sector invested in these markets declared itself effectively bankrupt, taking large amounts of British savings with it. British banks, who were heavily invested in the securities queued up to announce record losses. The Chancellor the most distinguished bankers found themselves gathered, shell shocked, staring into the abyss. But the actions they took seem to have averted the global depression. And despite continuing economic challenges, attention has turned to how we plan for a recovery that can deliver sustainable growth. I'm not here, however, to offer a defiance of the decisions and behaviors which led to the crisis. Instead, I'd like to focus on how we can put the right the problems of the past economic cycle and redouble the efforts of a sector that remains hugely valuable to us all. I would just like to highlight that at the start of the crisis, financial services only accounted for less than 8%.
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Of the total GDP of the UK.
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We provided 27% of its corporation tax and 15% of its income tax. Despite serious problems, it remains a vital sector punching well above its weight. For the uk, the real concern lies in the fact that over the last decade manufacturing fell by over a third. The challenge to me is clear not in how we restrain a bloated industry, but but how we refocus Financial Services on funding and supporting balanced growth across.
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The UK and the European Union.
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In this context, the crisis has exposed the limits of excess leverage by demonstrating its brutal nature in a falling market. It is clear that we need to find greater balance in our economy towards equity as a means of increasing the funding options for business business and also encouraging a savings culture in the UK through investment in UK plc. Let me be clear though. Debt finance is not necessarily a bad thing. The debt lent to unreliable customers, secured against volatile assets, securitized and priced using dubious methodology, leveraged again and again and again and funded using wholly unpredictable short term credit markets is indeed a recipe for economic disasters. There are actually two issues here. First, investors came to see debt instruments as having superior returns on investment. Traditionally, equities will provide better long term returns than basic government and corporate bonds.
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Pretty much 99% of the time.
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But bonds built from securitized debt and indeed leverage quasi insurance products like my own personal favorite credit default swaps, seem to offer greater returns than the stock market. But clearly they're also much more volatile. Investors must be far more restrained and retain a longer term focus in the returns they expect. Secondly, cheap interest rates for retail customers and the wholesale market, coupled with a tax system, particularly in the UK which makes debt hugely efficient, encourage this credit bubble. We cannot sustain interest rates at today's levels without laying the foundations for the next bubble. Greenspan's put as we refer to it in financial markets was effective at restabilizing the economy, just as it appears. Bernanke's put has been as well. But if we wait until we see evidence of a bubble before raising the rates, as was the case in 2006 on both sides of the Atlantic, we may find ourselves repeating the events of.
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The past 18 months.
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Of course, the impact of debt on the downside would be lessened if a greater proportion of our economy was financed.
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Through the other financing mechanism available to us, which is equity.
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The key difference between equity and debt is that equity financiers are incentivized to follow their money and support companies during a downturn rather than seize the assets. To use our markets as an example, we saw equity raising this year in excess of 106 billion pounds, the vast majority in further issues as companies started to repair and rebuild their balance sheets with the significant support of their existing investors. Equity finance for companies and equity investment by individuals are really, frankly, two sides of the same coin, fundamental to economic growth and prosperity in the modern society. On the one hand, equity finance plays vital role in supporting ventures large and small by helping companies meet their various needs for capital. On the other, it provides strong sustainable investment returns. It is an investment in jobs, wealth creation and in tax generation. It is the mechanism that matches capital to opportunity efficiently, the economy's engine of growth. The decline of manufacturing in the UK has a number of causes, most notably the difficulties in competing on price with the new economies. But the manufacturing sectors of the future, biotechnology, advanced engineering and clean tech, for example will rely significantly on equity funding. I said earlier that a tax paid by financial services was a significant percentage of the national total. In simple figures, it's just under about 30 billion pounds. In comparison, the total tax paid by companies in the FTSE 100, all of whom are in part equity funded, is around £78 billion a year now. That is more than the government's combined spend on housing, defense and transport. Equity finance is a powerful tool indeed for delivering sustainability. At the height of the crisis, the FTSE 100 lost 48% of its value. But the shares remain liquid, the prices transparent. Now the market has returned to nearly about 80% of its peak value. Fundamentally, with a direct equity investment, you can only lose the value you invested and are not so heavily leveraged that.
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A move in interest rates would cripple your balance sheet.
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But as the IMF argued in June this year, the balance of debt to equity has been significantly affected by the systemic bias of our tax system. This bias was a contributory factor to the crisis, distorting corporate finance behaviors towards excessive leverage through what amounts to a.
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Significant subsidization of debt.
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In the uk, debt costs are tax deductible, while equity capital is taxed four times through its life cycle at purchase through stamp duty, corporation tax, dividend income and capital gains on sale. It is not clear why such an extraordinary situation has come about, but as long as it remains in place, the leverage imbalance will remain. And there is an additional problem, and that is of domestic indebtedness. The UK has a significantly higher level of personal debt than many other countries, double the levels in the stock exchange, London Stock Exchange, sister markets company in.
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Italy, Borza Italiana, for example.
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I would suggest that the stark difference points toward a lack of traditional of financial capability and domestic financial management. We would certainly like to see, and not just because it would mean more business for the London Stock Exchange shareholders, the growth of the citizen investor as it already exists, for example in Italy, and the way that the majority of investors access equity. The exchange model has significant qualities of its own which could be employed to great systemic benefit across a wider range of assets. This model enables efficient interaction between investor capital and business entrepreneurialism. But it also has crucial benefits for the structure of the market, including relative simplicity, product standardization and perhaps even more.
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Importantly, clarity for investors.
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But I will focus on three key benefits in particular which I believe underpin the wider advantages of the model. Transparency, liquidity and neutrality. Starting with transparency. Sunshine, as we all know, is often.
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The very best disinfectant.
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Most universal benefit of the exchange model is its inherent transparency, which can refer to the visibility of trades of asset prices or the structure of the assets themselves, or even in the disclosure requirements that regulators and exchanges impose on their listed companies. Off exchange trading can result in significant structural inefficiencies in favor of groups with greater access and information. Compare, for example, the relative cheapness of asset price information on the stock exchange to the cost of engaging the team of advisors necessary to value a collateralized.
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Debt obligation, for example.
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And there are systemic implications to a lack of transparency in comparison to the informal inefficiencies of over the counter or OTC as we call them markets. The exchange mechanism provides real time and unarguable market pricing data. Movements in prices are therefore easy to see, allowing the market to absorb them on a live basis. Shocks are less damaging. The stringent disclosure and corporate governance requirements ensure that price sensitive information is released promptly to be interpreted and contextualized by the network of professionals which has developed to support the market. Bear Stearns, for example, offers an excellent example of the problems of asset price opacity. When Merrill lynch, one of Bayer's principal creditors, became concerned with their business model and threatened to sell the CDO assets against which their debt was secured, even the possibility of a mark to market price terrified. The difference between the assumed value of the assets and the real market price.
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Was likely in that case in particular.
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To be very significant. Equally, the growth of off balance sheet vehicles highlights crucial problems of transparency and capitalization. Investors, managers, rivals and regulators must be able to see as accurately as possible the risk profiles of banks with whom they operate. In the general sense, the suitability of capital requirements at 8% is the subject of industry debate. But when that 8% doesn't reflect the most at risk assets the bank holds and indeed assets which become impossible to value the moment the market loses liquidity, we cannot hope to have a sustainable economic system.
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Second characteristic was liquidity, and that refers.
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To the ease with which an asset can be bought and sold. Lots of buyers and sellers means obviously a liquid market. It is far from a purely technical concern.
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It has very direct implications for the.
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Price formation mechanism and therefore investor returns. The large gap or spread between the prices at which buyers will bid and sellers sell a share is a significant.
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Cost for illiquid stocks.
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For example, a couple thousand BP shares bought for around £11,000 and then immediately sold will incur spread costs of just about 2 pounds. But a similar sized deal in a relatively illiquid stock would incur a spread cost of around £130. Tremendous leverage between the two. Perhaps more importantly, the spread cost when shares are sold is priced into the amount that investor will be willing to pay for a company when it first sells its shares to investors. Put more simply, a liquid market between investors will significantly reduce the growth funding available to companies and employers across the uk. And during the crisis the liquidity was constant. It did not evaporate as it did.
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On the OTC markets. Third point is neutrality.
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These benefits of liquidity and transparency are.
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Matched by a commitment to neutrality.
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Market participants can be confident that the system on which they rely has not been designed to the advantage of of any particular user. This is very important buyer, seller or.
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Part of the infrastructure.
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Nor does the exchange use its access to price sensitive information to trade from an advantaged position. Some might refer to that as the old specialist system. For example, the exchange provides a high quality venue it in which everybody has the opportunity to participate on a democratic footing. OTC markets and counterparty risk. And when we look at OTC markets, these characteristics can seem somewhat abstract. I would like to convince you that they are actually nothing of the sort. As we began by talking about the problems in the securitization process, I will talk in applied terms about how the exchange model can offer significant advantages to many derivatives products currently traded on the OTC market. These derivatives include the mortgage backed securities mentioned earlier, but also many bespoke products structured to allow businesses to carry out hugely complicated financing. The big debate in finance is how much of this derivative market can be brought on exchange and how much can be cleared through a central counterparty, known.
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In our jargon as a ccp, which.
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Acts as an intermediary between the buyer.
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And seller, offering security of settlement for both.
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Certainly the disciplines of transparency, price discovery and liquidity that a visible market imposes would bring immense benefit, as would the counterparty risk management provided by ccp. When Lehman Brothers defaulted, central counterparties achieved nearly complete resolution of all open centrally cleared position within less than 15 trading days. Compare this to the lengthy process of.
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Unwinding the OTC positions, which by the.
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Way is still ongoing. At the moment only 10% of the derivatives market is trading on exchange. The transparency of standardizable products could be significantly enhanced by regulated exchange trading, but of course the benefits of the model are not a panacea either. And there are many derivatives product for which neither exchange trading nor clearing through.
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A CCP are suitable.
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The CCPs, which act as counterparty to both sides on an exchange deal, protecting both against the risk of the other not completing the transaction, do so by collecting a margin based on the potential loss in the event of a default. For a stock, this typically might be in the region of about 20% for a bespoke derivative, though particularly in the case of binary risk products like credit default swaps, this might potentially be as.
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High as 100% of the position.
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In some cases, accurately pricing this risk is a significant barrier to central clearing of any non standardized products. Attempts to make these assets centrally cleared would therefore be very possibly technically unachievable and certainly have the effect of centralizing risk in a vital piece of market infrastructure. We'd like to offer a warning in that context that this course of action could turn CCPs into into a significant source of future systemic risk. Clearinghouses carry counterparty risks far in excess of the balance sheets of all the banks combined and do not benefit from guarantees from the state that they would act as lender of last resort in.
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The event of a shock, particularly in this country.
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I would ask policymakers to think very carefully about what parts of the OTC market are brought on exchange and also about how a race to the bottom for CCP margins can indeed be avoided. And I believe there is a need for serious thought about whether governments should extend the lender of last resort protection to CCPs. There is no value to protecting the industry from market forces and fees should not be subject to the same protection as the risk margins charge. But I would warn that it is no one's interest for fees and margins to become so low that CCP's cease to be sustainable or even a potential element for systemic risk transmission. We must balance the need for competition with the need to preserve sustainable and well capitalized CCP institutions. Additionally, as with the broader regulation of financial services, we need almost desperately harmonization in regulatory structures, funding mechanisms and risk management frameworks for these clearinghouses and depositories. The key is to assign the most appropriate trading mechanism for each type of asset. Many derivatives in fact are not suitable for exchange trading. But for many others, exchange trading would offer the huge and structurally important benefits of transparency, liquidity, neutrality and standardization. In conclusion, I would like to just make a few short points. First of all, the process of recovery and recapitalization from this crisis is far from over. Nearly $600 trillion of untransparent OTC products remain in the financial system, 10 times the value of the total annual economic.
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Output of the world.
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Banks remain some distance from their recapitalization targets. Balanced funding policies are not in place, and although the savings ratio for the UK is certainly headed back in the right direction, we certainly cannot assume that the era of giant flat screen TVs and Ninja loans is passed. We will not have repaired our financial system from this crisis until these issues are addressed. But preventing a recurrence is the greater challenge. At the beginning I suggested we needed to reconsider the characteristics of the good economy. I might suggest profitable, sustainable, ethical, accessible, self sufficient and transparent.
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I'm sure you have some of your.
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Own, but these are the ones I.
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Could come up with.
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These characteristics don't include the absence of failure. Expansion and contraction of the markets is unavoidable and to some degree a political rather than economic issue. And I suspect an unsolvable one at that. But the peculiar characteristic of excessive leverage is to accelerate the effects of failure.
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In a systemic event.
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If long term capital management was the last crisis the market itself could afford.
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To repair, the credit crisis was the.
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Last one within the gift of the taxpayer. And so we must take responsibility for building a new approach to funding both business and investment. Equity finance and the exchange model stand Ready. The transparency, neutrality and liquidity they bring can be the basis of a sustainable financial settlement for us all.
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Thank you very much for your attention.
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Thank you.
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Howard Davies
Well, the motto of transparency, liquidity. Do you want to come sit back here? And liquidity has a certain kind of liberte, egalite, fraternite, echo to it. I felt that although it wasn't in French, it could have been. We've got time for questions. And the incentive is that anyone who asks a question will be invited up to the fifth floor for a drink afterwards. Actually, anyone who doesn't ask a question will also be invited up to a reception on the fifth floor afterwards. So perhaps the incentive is muted in this case. So who would like to. Yeah, if you could wait for a microphone, it's on its way to you now. If you'd give your name, that would be great. Thank you.
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Richard Melville
Richard Melville from Cellularity. Perhaps this is outside the remit of this discussion tonight, but as an open source developer, I feel obliged to ask this question. The London Stock Exchange recently announced and supplanted its Microsoft NET frame framework with an open source GNU Linux alternative. I'd be grateful if you could give us some idea of the thinking behind this dramatic move and how you feel that it would benefit the London Stock Exchange.
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Xavier Rolle
I could certainly give you the broad lines. I'm not sure everybody will be interested.
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Here in discussing the merits of a.
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Managed architectural middleware or the number of.
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Servers, throughputs and latencies. Let me just summarize by saying that.
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Our secondary market activities are intensely competitive, which actually is a good thing, because you cannot ask for exchanges to represent a solution to transparency and solution to the particular issues posed by OTC trading.
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If you do not provide a competitive.
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Framework properly priced and efficient.
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But it's clear today that investors require.
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Extremely scalable and extremely cheap technology that processes transactions very, very fast.
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And the reason why we reviewed our.
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Technology architecture essentially two things. In terms of the technical design, the.
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Peculiarities of the Microsoft.net Managed middleware architecture.
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Created such a hardware footprint that the operation and speed and ability for us.
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To innovate with new products was no longer competitive.
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In other words, our server footprint was substantially bigger, considering an equal level of throughput, than new ventures, new constructs. And I would also add that the London SOC Exchange was and still is, for a few more months, the only exchange in the world operating a managed architecture middleware. So it was an issue for us of cost, which was no longer competitive due to an excessive hardware footprint, a lack of throughput. I'm happy to give you some statistics if you care, but you know, we were at 4,000 messages per second. The new Linux C platforms were at a quarter million. They were less millisecond, less than a millisecond latencies. We were about 3.7 to 4 millisecond latencies. And some of those competitors just won't mention names. But we maintain about 1100 servers in our data center to process our secondary transactions. And those 1100 servers gave us a capacity of about 50 million orders per day. And as sort of the benchmark in terms of the sort of new MTFs or new technologies rolled out in the last 18 months was about a couple hundred servers handling two and a half to three billion orders a day. So delta in terms of throughput, delta in terms of latencies and the cost base of maintaining such a system were no longer competitive.
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Hence the decision which was a priority.
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For us and took the first three months, me taking over as the CEO first three months of my time, at least the bulk of my time was to identify a new technology solution. I hope I answered your question.
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Howard Davies
Thank you. Guy right at the back there, blue shirt.
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Xavier Rolle
Hello.
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Audience Member
Just to move off the intensely technical points, I think from.
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Xavier Rolle
I actually tried to spare you the technical part.
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Howard Davies
Oh God.
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Audience Member
Really, from the outside, looking at the crisis that we just or could still be going through, one of the things that seemed to be critical was the idea that even leaders were relying on experts to know what they were doing and without being sure. And one of the things that you mentioned was a growth of a citizen investor. I just thought, would it be possible to expand on that idea and why you think it's an important thing for us to be looking at?
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Xavier Rolle
Yeah, I mean, if I can give you the broad framework, it's clear that the traditional way, particularly in Europe, to fund economic growth, that is to invest and create jobs, has been to recycle excess capital generated by the industrial and service economy by the banking system. And that banking system provides leverage which is reflected on the bank's balance sheet. And that's a good thing because if you don't have leverage, basically the pace of economic growth and job creation would be a lot smaller. But when that leverage is excessive, you get into a crisis where banks need to repair their balance sheet. You then go into negative leverage because not only will they stop lending, but they will keep replenishing their balance sheet until the level at which they feel comfortable enough starting to lend. So it may be some time, even beyond the time at which they've actually replenished their balance sheet where that positive leverage comes into play. And what we're arguing is saying this.
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Is not if you regulate the levels.
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Of leverage properly, this is not a bad system and it's proven to be quite productive over the last 50 years. But what you need is to diversify a little bit away from that sort of singular way of funding economic growth by putting in place the mechanism by which pools available pools of capital can be directed to those who need it. And I'll give you an example so that you don't think my answer is.
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A bit verbose and theoretical.
- [42:00]
Let's talk about one interesting market we're going to launch in a couple of months. An initiative to create a retail enabled corporate fixed income market in the uk. No such thing today. There are a lot of retail investors in the UK today searching for yield. You, sir, might be looking for yield yourself to invest your investments. Maybe not today as a student, but in a few years when you engage on your career, if you give your money to a bank, you're going to get half a percent, if that. There are some excellent companies out there offering returns of 6, 7, 8, 9%. We have our own bond listed in the wholesale market which came out at nine and an eighth, you know, earlier basically in the year at times where yield went much higher. So there is demand, there's capital available looking for yields. There is the need on the corporate side, particularly the small and mid sized enterprises, to raise debt finance, which could be raised directly from retail investors. It could be individuals making that decision or it can be financial intermediaries handling the needs of retail investors.
- [43:04]
But today that is not happening for.
- [43:05]
A simple reason, is that a retail investor who wants to buy a corporate bond cannot see where this bond is trading. They cannot see the inside bid and offer, they cannot see how well it trades, they cannot see how it's traded in the last few years. So there is no confidence, there is no transparency, there is no neutrality and liquidity, at least not that is obvious to the eye, to the naked eye. So they won't invest. And similarly, the corporate issuers or the companies seeking to invest today will turn to bank. And unless they are the bluest of the blue chip or have a very solid balance sheet, they're very unlikely to get any finance or else the cost will be prohibitive. I hear small business owners calling for capital, asked to Pay rates of 20% from large banks. So there is that pool of capital available. There is the need for good companies to issue debt finance and it's the Same issue for equities. And we believe that by building a transparent neutral, again, an exchange is a neutral entity. It sits between the corporate issuers, the wholesale. On a large scale, medium and small size capital markets are effectively a contradiction. I mean it's a, it's a conflict of interest wrapped in a contradiction. The conflict of interest is you got buyers and sellers, issuers and investors. And by definition you need a neutral operator to keep the rule book and to keep the operation of that system in a correct state of play. But it's also a contradiction because if it is a monopoly and run for profit, it will extract monopoly rent. If it's a non monopoly, that is a competitive environment, fragmentation can actually detract from efficient pricing. So you need a neutral operator at the center. And by providing that infrastructure in times where the banks are temporarily out of the economic system, you provide a cheap, efficient, electronic, transparent, neutral way of matching needs for capital with those who have it.
- [45:09]
Thanks.
- [45:10]
Howard Davies
Man on the front row here. Yeah, that's a Brown. Yep, that's it.
- [45:15]
Audience Member
Hi, thank you for that wonderful lecture.
- [45:18]
Xavier Rolle
Could you give me a more descriptive.
- [45:23]
Audience Member
Idea towards transparency for dark pools, High frequency trading and short selling.
- [45:31]
Xavier Rolle
Okay, dark pools, high frequency traders and short selling. I start with the dark pools because transparency in the dark pool, bit of.
- [45:46]
A contradiction in terms.
- [45:47]
Dark pools are a little bit of a misnomer in the sense that they translate a need which has always existed.
- [45:54]
Since effectively institutional investing came to dominate financial market.
- [46:02]
There is a need for risk transference.
- [46:06]
On a wholesale scale. Wholesale basis.
- [46:11]
Institutions, corporates, banks, intermediaries need to transfer.
- [46:15]
Very, very large blocks of risks. It could be simple equity of bonds, it could be more complex securities, but in a fashion that if revealed on what we call a lit pool, that is a traditional exchange would so substantially unsettle the market that not only would make that transaction impossible, but would also introduce substantial useless volatility in the underlying market. This has always been a trademark of the London marketplace. The reason why London is what it is today in terms of its financial critical mass is because for decades you could get prices for market makers on any commodities, equities, bonds or any sort of financial instruments from around the world. London developed a market making risk intermediation culture which you did not find so much, in fact, sometimes not at all on the continent, very little in Asia, and also very, very limited in the us. So that risk intermediation culture was always in need of a transfer mechanism between wholesale players away from the lit retail market where that risk could be efficiently transferred and post the advent of regnms in the US and mifid here in October or November 2007, those risk transference venues were described or qualified as dark pools. So they're really only for the use of wholesale players. And here what we propose as an.
- [47:46]
Exchange is, rather than have these dark.
- [47:48]
Pools operate on the basis of just intermediaries governance, that is just bank shareholders or buy side shareholders, is to put an exchange in there to bring a neutral presence to ensure the rule book doesn't overly favor the interest of this or that constituencies. And even more importantly, in terms of reporting standard, particularly regulatory standard, the presence of an exchange helps achieve a higher standard of knowledge, behavior, but also regulatory reporting. So it's a variance on that. But that need will not go away. If you ban dark pools or if you ban crossing networks, that activity will just move elsewhere. Outside of Europe, outside of the us There will continue to be a need for transference of that risk.
- [48:35]
And that is also a need that.
- [48:37]
Corporate issuers, particularly very large corporations, it's not just necessarily about equities of fixed income. It could be a bespoke foreign exchange transaction, could be shifting a tax risk from one entity to another. Many different forms of transfers. High frequency traders.
- [48:53]
High frequency traders, I don't want to.
- [48:55]
Speak for them, but I would say by and large are not great lovers of dark pools. High frequency traders are statistical traders who frankly arbitrage away pricing differences, pricing behaviors differences, technological, to the gentleman's question earlier, technological design, differences between venues, fee schedule, they arbitrage any discrepancies, whether it's linked to the underlying investment or to the nature of the venue where they trade and seek to make money. So they need extremely fast but also extremely predictable asset behavior. And for that reason they like lit pool venues rather than dark pool venues, because the dark pool by definition is not predictable in terms of having access to that particular liquidity. So I don't think linking dark to HFTs is necessarily the right description.
- [49:52]
HFTs would not frankly exist.
- [49:55]
I mean, they are a direct result in their current modern incarnation of the fragmentation the financial markets. I mean, the more venues they have, by definition, and this is the contradiction referred to, if you have a single trading venue, by definition, mathematically you optimize liquidity and optimize or reduce the central spread because all liquidity converges in a single locus. As you get fragmentation, the spreads are going to have tiny little differences. If you can arbitrage the execution latencies, you create a business model. That's what the HFTs are doing.
- [50:32]
The third point is short selling.
- [50:34]
That's a very interesting question. The definition, when you say short selling, often you say you think of hedge funds. Short selling by definition is an activity you will only engage in if you forecast very significant profit opportunity. Given the fact that when you short sell, your potential loss is infinite, at least in theory. You're not going to sell short to security if you think you're going to make 5 or 10%.
- [51:02]
So you're going to sell a security.
- [51:03]
Short if you expect a very, very significant, or if you expect there's substantial downside, 40, 50%, you know.
- [51:14]
That sort of expected profit.
- [51:16]
So by definition, short sellers have very strong conviction about the fact that a particular securities is mispriced. And if they're right, they will benefit. And if they're right, buyers of that securities will also benefit by buying the security at the right price. So it is a necessary function in terms of correct pricing of particular securities if handled in a satisfactory way from a regulatory point of view. I mean, they can be manipulation linked to short selling, they can be manipulation.
- [51:48]
Linked to buying of securities.
- [51:51]
So the manipulative behavior in itself is not necessarily linked to that particular activity. But short selling is also an essential technique, trading technique. For example, without short selling or the ability to short sell, you wouldn't have a convertible market as simple as that. You cannot sell a security short. You're not going to be able to place any convertible securities just because of the requirement to hedge the delta risk. So it is a complex issue. We believe it is a necessary and obviously falls under regulation like any sort of activities. But it is a necessary trading technique to keep markets efficient. It is also by definition, I mean, it is the core definition of what a hedge fund is. Definition of a hedge fund is, at least originally, is the ability to short. There's nothing else coming from that ability to short. Obviously you generate cash, so you need to borrow in order to short. You need to have a margin account. And by definition you extract a funding capability from that short which you convert into leverage. So leverage was the result of the ability to short. But originally a hedge fund was singly an institution which could short.
- [53:06]
And of course, in the context of.
- [53:08]
Activism or other sort of campaigns, some of these investment institutions or hedge funds have sort of attracted some bad publicity to their activities. But we think it's important to retain the ability to shorten the market.
- [53:21]
And in fact, during the financial crisis.
- [53:23]
Markets that banned short selling saw smaller return and lower valuation than markets that didn't. Thank you.
- [53:32]
Howard Davies
Yeah, down Here, yellow tie. I'm intrigued by the neutrality because you are a shareholder owned for profit organization.
- [53:47]
Xavier Rolle
With shareholder interest of making a profit. So how do you ensure the neutrality in such a circumstance?
- [53:55]
Well, the fact that you're for profit, profit with shareholders being a public company means you're accessible to anyone. So if somebody feels, for example that they would like to have a stake in you, whether they are a wholesale bank, whether they're sovereign fund or whether an investment fund have easy public access to the securities, and we publish our numbers and we're regulated so that transparency and that availability to buy or to sell is a guarantee of neutrality.
- [54:23]
Which neutrality doesn't mean that we don't run our model for profit.
- [54:27]
I would hasten to say that, and this could be a question that I get, but I'm seeking to anticipate.
- [54:34]
If you look at the size of.
- [54:35]
The bonus pool of the London sake shed, you realize that we're on a.
- [54:38]
Per employee basis, definitely not part of the problem.
- [54:41]
So we're not there to extract monopoly rent.
- [54:44]
We're in a competitive environment. But what for for profit management does is over a long period of time.
- [54:52]
Versus the sort of utility type management.
- [54:55]
Is, it allows to attract employees, and that's management, but not just management employees.
- [55:01]
That are motivated to grow value for their shareholders.
- [55:04]
And over a long period of time that drives into improvements of the business.
- [55:08]
Model, cost reductions and innovation. And if we look at some of the largest companies involved in financial infrastructure.
- [55:17]
Not just in Europe, but so in.
- [55:19]
The US the ones that are operated so called as utilities and not for profit. And if you call the shareholders, but.
- [55:25]
Also the clients of such companies, you.
- [55:28]
Might find a fairly startling picture in terms of the general level of satisfaction, you know, with prices and innovation and products, it's not that high.
- [55:40]
So over time the utility model tends.
- [55:42]
To not immediately, but tends to innovate less, tends to put itself into question less because of the lack of competitive pressure.
- [55:50]
So we believe in competition.
- [55:52]
We also believe in transparency. And the fact that an institutional asset manager, a wholesale bank, a retail bank or a sovereign fund can own us.
- [56:02]
Also has simple consequences that because we.
- [56:07]
Are a regulated entity and we can be owned by any and all financial investors.
- [56:12]
When we design our rule book, when.
- [56:14]
We look at our structure, we're very careful. Obviously there is an overarching regulatory obligation.
- [56:19]
And responsibility, but we're very careful not to design anything that seeks to court.
- [56:26]
Or to advantage too much the advantage of one particular constituency or another. And it's economic self interest. Our own shareholder list reflects that diversity and that in that sense that we say that neutrality is in important, particularly of course as we get into things like dark pools and other crossing networks, it also gives us in the long.
- [56:45]
Run and we are starting to see the effects of that materialize.
- [56:48]
For those of you who are interested in our industry, you know there are a number of ongoing transactions that have.
- [56:53]
Been discussed in the press.
- [56:56]
It gives you a governance stability. Let's say that you have an infrastructure venue that is owned by users and.
- [57:05]
Only users that by the way happen.
- [57:07]
To be competitors over time their ability.
- [57:11]
Sitting around the table to agree on.
- [57:13]
A business model, to agree on management changes, to agree on strategic developments, on new product introductions, on any sort of new developments affecting the company is looked.
- [57:27]
At not just from the prism of any fact, less and less looked at.
- [57:31]
From the prism of economic validity, but more in terms of those users self interest. And it becomes more and more difficult over time to agree on the long term governance and business direction of that entity. And it is for that reason that some entities, we've seen some of them recently being put up for sale. One of the reasons why they are not able to remain is because of the, the fact that certain business constituencies or competitors are holding the key to governance, make them fundamentally unstable.
- [58:03]
And part of us being a public.
- [58:05]
Company accessible to any kinds of shareholders is also that it gives us in the long run a stable governance that's very important. Thank you.
- [58:15]
Howard Davies
Gosh, I'll take a woman in red shirt on the second row there.
- [58:32]
Xavier Rolle
I was just wondering what is your plan as new CEO to maintain the LSE position as definitely the reference in Europe and well in London and if possible in Europe and worldwide after the crisis. Thank you. Thank you very much. Actually I'm an old CEO, I've been there six months now. It's starting to show.
- [58:55]
The presence and.
- [58:56]
Relevance of London Stock Exchange. I would say we continue clearly in the area of equities to be a leader in Europe. But if you look for example at one of our main functions which is to raise primary and secondary capital for companies in the area, for example primary equity capital, we're by far a world champion. I mean if you look at, and it's obviously time for a pitch here.
- [59:23]
I think you all felt it.
- [59:24]
But if you look at how much money we've raised in the last 12 months, it's in excess of $155 billion. That's more than our, you know, four nearest competitors put together and that includes the NYC, NASDAQ, Deutsche Bosen, Tokyo Stock Exchange. Exchange. So in the area of primary and secondary capital raising, we are by far the biggest and most successful exchange in the world. And hence the brand that comes attached to this. And this is a vital responsibility not only to the UK economy, but to the economy of the world, including the European economy. Out of the 3,500 companies that are listed on the stock exchange, 868 are non European companies, foreign companies. It's really the place where companies from around the world, be they Russian, Mexican, Indian, Chinese or others, come to be listed, either if they want an international listing or if they're seeking for a listing outside of their home country. It's the sort of first port of call in that respect. We will not only not do anything to distract from that mission, but continue to working very closely with all the players and actors of the City of London. It's the banks, it's the accountants, the regulators, it's the lawyers, it's all the players that contribute to making London a special place. We'll continue to work with them to continue to make sure that London remains very, very competitive. I'll give you a simple set of statistics. For £1 of listing revenue that we collect, our fees, I promise you, are very, very reasonable. For one pound of listing revenue to collect, the City of London collects £1,000. So that's the investment banks, that's the lawyers, that's the accountants, that's the all the service companies, the PR firms. So we clearly there's a very, very highly leveraged wealth creation or economic value creation mechanism here. And that is exciting. Clearly a responsibility and a mission we have within London, City of London, for the UK economy. In the secondary area, the markets have been open to competition. On the back of MiFID, there are now about 47 MTFs operating across the board In Europe, we're also starting to compete in between exchange. Hence the necessity for us a few months ago to substantially revamp and modernize our technology and make it competitive. Because it's about, in the long run, modernizing technology. It's about cutting our cost so we can cut our fees. And the competitive dynamics there is very clear. If you look at Europe overall, the daily equity turnover in Western European markets is a bit less than $30 billion a day. Europe represents about 31% oil GDP. If you look at a comparable economy, the US economy, which represents a bit less than it's about 27% world GDP. If my memory is correct, daily equity turnover is $300 billion a day. So if we as exchange through competition, but through promoting A better business mix, modernize our technology, reduce our costs, basically scale up our services. We can help by lowering our fees together with the central counterparties, together with the csd, together with all the other infrastructure participants in the European economy, help bring about a substantial boost and increase in traded volume and that increased liquidity. And as we saw, the Delta between the US and Europe is one for 10. It's considerable. It's considerable that boosting liquidity will obviously first and foremost benefit companies who will be able to raise capital more easily at a cheaper price. So we also have a responsibility to the corporate world. And that of course leads to job creation and investment to continue to modernize and remain very competitive. Now, this will lead eventually, I mean, as in all things, increased competition, commoditized products, particularly in cash equities, leads of course to reduction in cost, scaling up the technology innovation and possibly down the road, yes, also consolidation. But it's quite important for us in terms of our corporate business strategy to also grow a significant part of our product portfolio which is not related to equities. We own the largest government bond trading platform in Europe, the most successful corporate retail fixed income trading platform, MOTT in Italy, the third largest equity derivative exchange, distant third nonetheless, I'll grant you that. But the third largest equity derivative exchange in Europe, EDAM and many other such platform. The second largest electricity trading commodity exchange, EDEX, a large clearing and counterparty entity called CCNG in Italy, a large CSD managing about 2,500 billion euros of custody assets. So there's a lot more to London Stock Exchange than just cash equities. I know this is what the press is focusing on. UK cash equities represent about 17% of our revenues. And the challenge and the opportunity for London is for us to scale up that portfolio product, expand impulse trade, expanding derivatives, frankly, expanding fixed income, because that will make us a more relevant entity within the European sphere and within the global sphere.
- [65:02]
Howard Davies
We're running up against the strategic imperative of going upstairs for a drink shortly. So I'm going to take one more question. I think I had you sort of go in the third row, I'm afraid. Yeah, that's right.
- [65:16]
Audience Member
Hi, I work in the online financial trading industry, especially the leveraged trading industry. So 14 years ago, a company called CMC Markets launched FX Online to provide institutional services to the retail world. And today what's happening is half of the G10 banks are in our industry. So Goldman bought 10% of CMC, RBs have launched CFD products, which are famous for leveraged equity trading Deutsche Bank, Barclays, et cetera, are entering our industry. And I just wanted to know your opinion on the future of our industry. For brokers like AL, Paris, CMC, et.
- [66:05]
Xavier Rolle
Cetera, I think you've had the opportunity for a pitch as well, so.
- [66:10]
Only fair.
- [66:10]
It's only fair.
- [66:12]
What's my opinion of the future of the online industry?
- [66:15]
I think it's got to be a bright future. By definition, if you provide an efficient service, electronic trading, at the right cost, with the proper design, the proper algorithms, so you give access to liquidity, you should have a lot of takers. But I think your future is also correlated to the continuous upgrade and improvements in financial infrastructure in Europe. So your future is also dependent on how the risk that you create by generating trading flows is actually cleared and settled. So it's not just about the new technology design, the new products, innovation, you know, the cheap fees that you will charge, that's very, very important. And the new business segments you create by giving access to new constituencies of clients, certain pockets of retail investors, institutional or whatever.
- [67:13]
But it's also how you do that.
- [67:15]
And get support, make sure that the CCPs, the clearing industry, support that particular particularly cross border. There's a clear issue here in Europe at the moment with a lack of regulatory harmonization of the way CCPS and clearing and csds are regulated, for example. So that's very important to your business because as the EU looks at it together with the euk, what comes out of that may be very supportive of a more competitive financial market or maybe restrictive as regards future competition. And so the future should be bright, but it's also dependent on what else would be done to make sure that these increased trading flows are properly cleared and are properly settled. And then I would say in Europe, looking particularly at the us, the challenge is pretty vast. We still have a lot of wood to chop to make the post trade infrastructure and, and framework in Europe much more efficient than it is today.
- [68:23]
Howard Davies
I'm sure I speak for everybody here when I say this was an extremely thoughtful and thought provoking presentation this evening with lots of, to me, very interesting ideas about the role of exchanges in the future. Bringing derivatives on exchange and some of the competitive issues you raise, I think very interesting as well. So thank you very much for that. And also to reiterate that there is a drink upstairs for those who would like to join us, and I hope many of you will on the fifth floor. Those of you who are not particularly fit can go up in the lifts. Anyone who of course wants a career in the city. And the thrusting city will have to run up the stairs and show your eagerness. But we hope we'll see a number of you up there on the fifth floor in the senior dining room. But before then, let me thank Xavier for coming. Very, very exciting.