Michael Aitken

Over the weekend four European countries (France, Italy, Spain and Belgium) extended their ban on all forms of short-selling in a bid to cushion bank stocks from the euro debt crisis, after what is considered unwelcome volatility, particularly in the banking sector, and in particular, in the stock Societe Generale.

Despite a raft of consistent and convincing academic evidence that such action is ill advised, regulators in these countries have never-the-less decided to bury their heads in the sand. I suggest this points to a fundamental problem with securities regulators around the world, namely the failure to embrace the concept of evidenced based policy making.

When the SEC in the USA made a similar decision to ban short-selling  back in the global financial crisis, ASIC and many other regulators also followed suit, presumably because either they thought the SEC knew best (a dangerous assumption at the best of times) or investors would take their frustrations out on our market if we left them to do so.  Despite all the gloom and doom, places like Hong Kong did not follow suit and their markets did not suffer the catastrophe that was predicted.

So why is it that in the face of the available evidence, that banning short-selling is not a useful idea, do regulators still do it? Perhaps the answer is that like the proverbial “cat caught in the headlights,” when they don’t really know what to do, running backwards and forwards looking like they are making conscious decisions will get them the benefit of the doubt if the worst happens. Trouble is, like the cat in the headlight they will still get run over by the car because the volatility will find a way to manifest itself if not today then tomorrow. Russia found this out when it tried to close its markets to avoid the consequences of the GFC and 9/11. As soon as they opened them again, they were hit hard because like the issues underlying the volatility in Europe they are more long-term in nature.

Our own regulator is not immune from the criticism that it acts in the face of the available evidence, as is evident in CP 145 which is contemplating the introduction of market design changes like uniform circuit breakers in an attempt to hold back the dam of negative sentiment.

There is no evidence to support this proposed market design change. The only evidence that does exist, provided by researchers at the Capital Markets Cooperative Research Centre (CMCRC) here in Australia, suggests otherwise.   Researchers at the centre developed a research design that looks at what happened to individual stocks that were halted for the release of information against the same stocks with similar price changes but no halts. The conclusion of the centre’s research was that volatility was higher in the aftermath of stocks that were halted than in the situations where the stocks were not. The logic is the same at the opening of the market. When the market has been closed for 18 hours people don’t really know what the price is and consequently we see significant volatility at the open relative to every other point in the trading day.

The decision to propose uniform circuit breakers here in Australia seems to have been taken based on the fact that other regulators were contemplating similar changes.  Indeed in CP 145 ASIC sites the decision by the SEC (which had no evidence to support it) as a primary reason for ASIC’s decision.

To break out of this cycle of following everyone else’s mistake there has to be an appeal to evidenced based policy making. Every time there is a market design change, the party motivating the change (whether it be a regulator, a market operator a broker or a trader) needs to confront the change pre and post with objective evidence of the likely impact of the change on fairness and efficiency, the uniform mandate of every single regulator in the world.  To do this we need to define and seek empirical proxies for fairness and efficiency and require parties motivating a change to demonstrate that the change will enhance fairness and efficiency or will enhance one without affecting the other before it is implemented or confirmed.

Researchers at the CMCRC are leading the way by demonstrating how evidenced based policy making is achievable. The framework they have created to address the issue, known as the Market Quality Framework, is designed for use by all would be motivators of market design change in securities markets.

In brief the framework identifies two key proxies for efficiency, namely, transactions cost and price discovery and three proxies for integrity, namely, insider trading, market manipulation and broker-client conflict.  We measure the proxies pre and post market design changes to provide objective evidence of the impact of market design changes on efficiency and integrity. The full framework is available from the CMCRC. So how might such a framework be useful?

Using the framework ASIC could demonstrate how the changes to the market it is contemplating in CP 145 would affect the efficiency and integrity of the Australian marketplace. Having such a framework may have saved Chi-X the four years wait it had to endure to secure a market licence in Australia. Had they provided evidence using the framework of the effect on efficiency and integrity of the introduction of Chi-X in the UK market, they might have got their go ahead a lot earlier. Had Magnus Booker used the framework to show how a merger of SGX and ASX would lead to enhancements in efficiency and integrity for Australian investors he might not be lamenting the Government decision.  At the very worst the ACCC would have had to address the evidence rather than appealing to the old chess nut that it was not in the national interest.

Of course studying market design changes elsewhere is no guarantee for what will happen here because a market at a point in time is the end result of hundreds of different market design changes over many years. In consequence this dictates the need for a study post the change in the market in question to confirm that expected outcome eventuated. That is the essence of evidenced based policy making which regrettably is in short supply in most regulatory decision making.

Michael J Aitken is the Chair of Capital Market Technologies at the Australian School of Business