Conferences & Events

A Conference Overview:
The Promises and Challenges of e-finance

by Paula Tkac, financial economist, Federal Reserve Bank of Atlanta

What is e-finance? Edward Green of the Federal Reserve Bank of Chicago describes it as “the financial sector analog of ‘flexible manufacturing’ . . . a constellation of mutually supporting business practices, technologies, and strategic managerial approaches that, when jointly adapted, can dramatically enhance the efficiency of market institutions.” In financial markets, dramatic innovations in technology and electronic communications have made these new practices possible.

Policymakers, financial market participants, and academic researchers met at Sea Island, Georgia, in October 2000 specifically to explore the electronic revolution in securities trading and trade processing. The discussions centered on three main issues: market consolidation versus fragmentation, the increase in retail investing, and the challenges of redesigning infrastructure to ensure reliable clearing and settlement systems.

Market Consolidation versus Fragmentation
Are securities markets becoming more consolidated? Will one large, centralized exchange be the inevitable result, or can multiple exchanges continue to exist and thrive? There has been a general trend toward market consolidation with the number of exchanges shrinking in the twentieth century. In the United States, however, several new trading venues have literally come on-line—completely electronic networks called ECNs (electronic communication networks) and ATSs (alternative trading systems).

The cost of creating these new exchanges is small because they are built on innovations in communications technology and the capabilities of the Internet. But according to Securities and Exchange Commission (SEC) definitions, these venues are not technically exchanges. Thus the New York Stock Exchange (NYSE) and regional exchanges compete against these new venues under slightly different regulatory regimes. Such competition, as in any industry, will likely encourage innovation and lower transactions costs, but it also creates complications. For example, when a given stock issue trades on many venues simultaneously, it may have many different prices.

The question for the exchanges is, Will we survive? The broader question facing regulators is, Does such competition result in more efficient capital flows to the listed firms, lowering their cost of capital, and facilitate growth? Or does the fragmentation that comes with multiple exchanges limit the ability of the market to use prices as a signal of where capital can be most efficiently used?

The Rise of the Retail Investor
As electronic communication has improved, the fixed cost of executing a small retail order has fallen to the point where individual retail trades have become more profitable. Many of the new trading venues arose to serve the investing public, who were attracted by the lower trading costs. While increased trading opportunities seem to represent an improvement, there are complicated issues involved in measuring the ultimate benefits to retail traders. As professional participants compete for retail orders, questions concerning what constitutes “best execution” rise to the forefront. Is price the only dimension along which customer service should be measured, or are the time to execution and the certainty that the trade will be executed important as well?

Redesigning Infrastructure
Underlying all of these more public developments is the nuts and bolts of any financial system—the “back room” where trades are cleared and settled once they’ve been executed. A trustworthy clearing and settlement system allows a financial market to function as it ensures investors that counterparties will make good on their transactions. The rise of trading volume from the new exchanges poses a challenge to such systems while new technology brings an opportunity to overcome such challenges. Settlement, in particular—the actual transfer of funds and assets between buyer and seller—can benefit from technological innovations. Currently the SEC requires that equity trades be settled within three business days, an arrangement termed T+3 settlement. New developments in the electronic execution of trades can speed up the settlement process, but what more is needed to make T+1 (or even T+0) settlement a reality in the near future?

These questions have no clear and easy answers. Each involves recognition of the underlying economic forces at work, a thorough understanding of the logistics of a sophisticated financial market, and a system of regulation geared to both protect participants and facilitate efficient securities trading.

In his remarks to conference participants, Federal Reserve Chairman Alan Greenspan made this final point very clear as he stressed the need for regulators and policymakers to allow the market to run its course: “Electronic finance represents an acceleration of the process that noted economist Joseph Schumpeter many years ago termed “creative destruction”—the continuous shift in which new technologies push out the old. . . . Policymakers should resist any temptation to preserve the franchise values of some institutions by protecting them from competition from other institutions that are better able to take advantage of the new technologies.” He called on policymakers to promote disclosure, increase transparency, and subject their own regulatory approaches to the discipline of the changing market.

At the time and in the context of the conference, it seemed clear that Greenspan was referring to the “old” ways of doing business: physical exchanges like the NYSE and traditional settlement systems would need to make way for new, more efficient technologies. However, the ensuing months have illustrated that “creative destruction” is a market force that affects all businesses—even those built from the newest technological innovation.

The explosion of on-line retail stock trading that fed many of the trading innovations has dropped dramatically with the losses in the market as a whole and Nasdaq in particular. Trading activity at firms like E-trade and Schwab is down 40 to 50 percent from year-ago levels, and their market capitalizations have fallen even more. A business model will prove successful only by weathering both high and low demand, and the new technologies are now being put to their first test.

These issues become all the more important and complex as the globalization of financial markets increases. The issue of whether one exchange or many will best serve both investors and firms in the market for capital is magnified as one considers the possibility of one worldwide stock exchange. Additionally, the advent of twenty-four-hour equity trading across countries with varying regulations, currencies, and infrastructure will be a major challenge for regulators. Further advances in technology will make global opportunities possible, but the market structures that will ultimately survive can be determined only over time—as the market runs its course.