Alternative trading places

Tradepoint Financial Networks, a company based in Covent Garden and listed on the Vancouver Stock Exchange, was recognised by the Securities and Investment Board as a Recognised Investment Exchange on 8 June 1995.

Tradepoint will be an order-driven market aimed at facilitating secondary market trading between institutional fund managers and broker dealers.

The rules of the Stock Exchange currently govern dealing activity in domestic equity securities by member firms. If Tradepoint is successful, a significant amount of trading will take place on an exchange, but not on the Exchange.

On 17 August, the Stock Exchange issued a consultation document proposing a number of far-reaching changes to its rule book prior to the anticipated start date of Tradepoint on 21 September.

This imminent increase in competition in UK equity markets has raised a number of serious issues of the supervision and regulation of the market.

These are the main issues in the consultation document:

Rule 2.9 loosely follows the provisions of section 47 of the Financial Services Act and prohibits member firms from engaging in any course of conduct which creates “a false or misleading impression as to the market in or the price or value of any security”.

Should the Exchange limit this rule to its own market, leaving Tradepoint and any other exchanges to monitor their own markets, or should it remain the Exchange's responsibility to monitor all the trading activity of member firms?

The Exchange proposes that Rule 2.21, which requires member firms to correct inaccurate statements made about a firm's client or counterparty in relation to “any transaction

effected through or with the firm”, remains notwithstanding that the transaction was not

effected through the Exchange.

Rule 2.12(b) prohibits member firms trading in securities which have been suspended or trading halted by the Exchange, either on or off it. The Exchange proposes to retain this rule (so that it would preclude trading through Tradepoint) as far as suspended shares are concerned. In practice, however, the impact of this may be limited as Tradepoint has indicated that it intends to follow any suspension of securities by the Exchange.

Rule 4.18 prohibits a market maker entering prices for a SEAQ security in a public price display system which are more competitive in price or size, or both, than that displayed on SEAQ. The Director General of Fair Trading concluded

earlier this year that this rule was anti-competitive.

The Exchange proposes that this rule helps both broker, in satisfying its “best execution” obligations at minimum cost and administrative burden, and the individual private investor who would not have access to better prices available only to closed user groups of favoured clients of the market maker.

Rule 4.50 requires firms to report to the Exchange all transactions by member firms in domestic equity market securities.

This enables the Exchange to supervise the activity of market makers; but can the Exchange properly carry out this role unless all trades by market makers are reported to it?

There are also a number of issues which could increase the administrative burden of using Tradepoint; duplication of stationery and contract notes which refer to membership of the Exchange. The Exchange has said that it will seek to mitigate additional cost and complexity wherever possible.

An order-driven system rather than a quote-driven system may help market participants to avoid some practical problems, although it will not be a panacea. The anonymity of dealing on Tradepoint will assist brokers in moving large orders without signalling their position. But market makers have always sought to mitigate the effects of their obligation to quote prices on, and deal in, all the stocks they cover, by not quoting their best prices on-screen and, then, only for small trades, by having large spreads between buy and sell prices; also by use of the 'chat' order (whereby market-makers chat on the phone when the market moves dramatically, so that all the lines are engaged).

However, the lower commissions on Tradepoint and its facility to enable institutions to deal directly with each other without using a market maker, may force market makers to react by narrowing the spreads and quoting more competitive prices and commission rates.

From the company lawyers' perspective, however, it is neither the benefits of an alternative type of dealing facility nor the effects of competition which are at issue here, but rather the fragmentation of the market and the issues that raises for regulation of market participants and market-abusers.

If Tradepoint is successful then we can perhaps expect fragmentation of other sections of the current market and the Stock Exchange's monopoly being further eroded.

Tim Steadman is a partner in the company department at Herbert Smith.