Future Present blog series
EFI is publishing a series of blogs that invite our community to respond to the existing crisis of COVID-19 through a variety of lenses. These lenses, economy, sustainability, creativity, history, health, justice, education, democracy, societies, are some of the themes critical to recovery. Members of the EFI community from across the University, different Schools, disciplines and experiences, will share their work and insight and help us consider our present future.
For our second article in the series, EFI’s Director of Financial Services and FinTech, Dr Gbenga Ibikunle, considers the impact of the coronavirus pandemic on financial markets, and what this means for our economic future.
The coronavirus pandemic is financial markets’ greatest ‘grey rhino’ (but it won’t be the last)
The term ‘grey rhino’ could not be more apt for the coronavirus pandemic. Still, when American author Michele Wucker coined it in 2016 to describe ‘highly probable, high impact yet neglected threats’ – such as the 2008 housing market collapse and Hurricane Katrina – even she did not foresee the impact it would have. Despite a series of warnings and visible evidence, no-one did.
The global economic cost of this human tragedy becomes more evident by the day. COVID-19 has had a more significant impact on financial markets than any pandemic before, which matters because how well financial markets work affects us all. They are where we – directly or indirectly – invest most of our retirement savings. Their performance determines everything from how many jobs there are and our incomes, to our credit card and mortgage interest rates. Investigating the impact of the coronavirus pandemic on market quality is crucial to understand how to deal with future grey rhinos and ensure the integrity of the global economy.
But first a recent history of financial markets
During the past two decades, regulation and technology have significantly changed the structure of financial markets. A significant outcome of this evolution has been the emergence of so-called ‘dark pools’. Whereas in traditional ‘lit’ venues, such as the London Stock Exchange, each investor can see the prices others are willing to buy and sell at, and the size of each transaction, dark pools such as Turquoise Plato only publish the sale price of previous trades. In April 2019, dark pools trades accounted for more than nine per cent of all European share transactions. In the US in the same month, dark pools and other off-exchange trading venues executed 38.6% of equity trades.
Dark pools’ lack of transparency is not necessarily a bad thing; my research demonstrates when used in moderation, dark pools can reduce the cost of trading and ensure fair pricing. Crucially, they protect large institutional investors, such as our pension funds, from the detrimental volatility of trading with informed traders. These professional traders use institutional investors’ urgency to cash-in their stock – often to release value to pay pensions – and their superior knowledge of how to value assets based on their fundamental characteristics to profit from buying them below-market value.
How has the coronavirus pandemic disrupted markets?
Khaladdin Rzayev from The London School of Economics and I studied the impact of the coronavirus pandemic on financial markets in Europe. Our results suggest that the effects of COVID-19 drove informed traders to dark pools because the cost of trading had become excessive in lit venues.
In turn, many uninformed investors, warier of informed traders than the rising cost of trading in the lit venues, migrated to lit markets. As a result, the proportion of trading in dark pools was 16% lower between 24th February and 24th March 2020 than the month earlier. This switch matters because the resulting excessive volatility in lit markets leads to higher trading costs, inefficiently priced stocks for institutional investors and, subsequently, potentially poorer pension performance. It could also mean higher borrowing rates for you and me in the absence of regulatory intervention. At least in the short-term.
Volatility as a market regulating mechanism?
Financial markets are flexible, and our analysis demonstrates traders self-regulate by moving between lit and dark exchanges when faced with volatility caused by grey rhinos such as the coronavirus pandemic. However, the fact their self-corrections are not flawless means there is still a vital role for regulators to play in improving fairness in financial markets and ensuring they work well for consumers and the economy as a whole. Nevertheless, the arduous task of ensuring fairness in this complicated ecosystem too often pushes regulators to look for uncomplicated solutions.
The next grey rhino
As our research indicates, provisions designed for normal trading conditions quickly become irrelevant when global events impact financial markets. Mechanisms such as the dark trading caps and waivers currently being extended by regulators are likely to cause more harm than good if they inhibit necessary market flexibility. The message for those considering the future of financial regulation during the coronavirus pandemic is clear. Heed the warnings and study the visible evidence of its effects today or the next grey rhino may come from within the economic structure itself.
Gbenga Ibikunle, Director of FS and FinTech