Streamlining Cross-Border Trading

Foreign exchanges eye U.S. traders under SEC initiative

Securities and Exchange Commission plans that would make it easier for foreign exchanges to operate in the U.S. are getting mixed reviews. Foreign stock exchanges see business opportunities in the SEC’s proposed scheme of “mutual recognition.” U.S. broker-dealers and others are uncertain, although cautiously optimistic.

“We think it will make the U.K. market more attractive to U.S. investors,” Adam Kinsley, the London Stock Exchange’s director of regulation told Traders Magazine. “And that is something we are interested in doing.”

From the Toronto Stock Exchange, spokesperson Steve Kee says: “We fully support it and believe it would be great for Canada. Given the amount of cross-border activity between Canada and the U.S., it’s important that Canada be on the mutual recognition list.”

Last month, the SEC announced a set of preliminary measures it hopes will pave the way for mutual recognition arrangements with foreign regulators.

The SEC hopes to ultimately sign memorandums of understanding with certain “high-quality” regulatory regimes. These will spell out to what extent the countries’ exchanges and broker-dealers can operate in the U.S.

The idea is to let foreign exchanges and brokers solicit U.S. customers for the trading of foreign securities without coming under SEC registration. And by cooperating with foreign regulators, the SEC will still be able to protect U.S. investors.

The plan follows statements SEC officials made last year indicating it was exploring the possibility of easing restrictions on foreign players as long as it was comfortable with the rules and practices of their home regulators.

The first country to get the thumbs up from the SEC, despite its relatively small share of U.S. investors’ wallets, is Australia. In a statement, the SEC said it had begun “formal discussions to develop a mutual recognition arrangement” with the Australian Securities and Investment Commission and the Australian Treasury Department.

Investments in Australian equities by U.S. investors totaled only $102 billion in 2006, the last year for which data is available, according to a survey conducted jointly by the Federal Reserve and the U.S. Treasury. That compares to investments of $674 billion in U.K. names, $544 billion in Japanese stocks, and $298 billion in Canadian stocks.

Most of the pressure on the SEC to loosen its rules governing foreign exchanges and broker-dealers has come from the Europeans and the Canadians.

Direct Members

As it stands now, a foreign stock exchange wanting to recruit U.S.-based broker-dealers for membership must register as a U.S. stock exchange. “As we have no interest in trading U.S. securities,” Kinsley explains, “that is something we would not look to do.”

It means U.S.-based broker-dealers cannot-except in very limited circumstances-become direct members of the LSE and other overseas exchanges.

Those U.S. brokers that are members of foreign exchanges have all established offices in the exchanges’ countries or nearby countries. By and large, they are exclusively the large global brokerages.

Because of this, any mutual recognition scheme is unlikely to benefit the bigger firms. It is the mid-sized brokers that the foreign exchanges have their eyes on.

Lee Hodgkinson, chief executive at SWX Europe, which trades Swiss blue chips, shares Kinsley’s view that smaller U.S. brokers are at a disadvantage when trading on foreign marts because of their need to transact through other brokerages.

Hodgkinson expects they will benefit under mutual recognition. “The firms that go through those banks will now gain control,” Hodgkinson says. “We would expect to recruit them aggressively.” Hodgkinson notes U.S. brokers will still need to enter into arrangements with foreign brokers for clearing and settlement purposes.

Both Hodgkinson and Kinsley expect to increase order flow to their exchanges. Though, neither would say whether they have plans to open up offices in the U.S. Kinsley points out it is probably not necessary to do so.

Extra Steps

According to the LSE’s Kinsley, the benefits on the U.S. side of the Atlantic are two: lower transaction costs and greater SEC oversight.

“U.S. investors are probably paying more to invest in U.K. securities than their U.K. counterparts,” Kinsley says. “It seems that is a sensible reason for the SEC to want to remove that friction.”

The extra cost is due to the number of brokers involved in the trade. A regional brokerage that does not belong to the LSE must work through a brokerage that does. That adds steps and costs.

It also eliminates the SEC from the equation. The regulator is unable to police the trade. If it were to enter into an agreement with the U.K.’s Financial Services Authority, the SEC would be able to stay on top of the trade, Kinsley argues.

What exchanges such as the LSE want is to put their “screens” on U.S.’ brokers’ desktops. That’s the language of the SEC anyway. In practice, it means adapting a trader’s order/execution management system or market data application to be able to trade directly on a foreign book.

“The way people will connect to the market is through these same systems,” Kinsley says. “They’re just not enabled at the moment.”

Will there be a rush to trade directly on exchanges covered under mutual recognition schemes? Opinions among U.S. broker-dealers and attorneys run the gamut. Uncertainty is mixed with skepticism and optimism.

Most U.S. firms that do a significant amount of international trading have long had overseas offices that permit them exchange memberships. It is the smaller broker-dealers that are up for grabs.

Will they abandon the intermediaries they currently use for remote membership? Pat Toomey runs the international desk at Knight Capital Markets, where he manages orders for foreign securities for Knight’s retail brokerage customers.

Toomey doesn’t expect any mutual recognition ruling to impact his operation too much, but he acknowledges “it could be a positive for U.S. broker-dealers because it gives them easier access to equities on foreign exchanges.”

Ed Johnsen is an attorney with Winston & Strawn, representing broker-dealers and money managers. He has gotten interest in mutual recognition from both sellside and buyside clients. On the buyside, firms are looking to trade more overseas, he says.

But the concern is over speed. They want to get the trades done quickly. “Any of the things that slow the process down raise concerns for institutional investors,” Johnsen says. “So creating a mechanism where the foreign exchanges could more efficiently access the U.S. market without full registration as U.S. exchanges would be beneficial just in enabling people to get trades done more quickly.”

Not everyone sees value in the SEC’s initiative. David Grayson, co-founder and partner in Auerbach Grayson, an institutional brokerage that specializes in trades in foreign markets, contends that U.S. brokers will still need to work through local intermediaries even if foreign exchanges can solicit their business in the U.S. “I don’t see that anything will change,” Grayson says.

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