Over-the-counter markets for derivatives have been a subject of blame for the global crisis. This column argues that the rising opacity and barriers to entry in these markets have been sorely overlooked leading to dark pools, flash trading, and front-running. These unfair practises can – at any time – cripple markets. They undermine the premise of free markets and should be stopped.
While over-the-counter markets for collateralised debt obligations and credit default swaps are blamed for the financial crisis of 2007-2009, what has been overlooked is the menace of rising opacity in the exchange-traded market. This raises questions about the fundamentals of this market’s very existence, i.e. transparency and equal access to one and all in the price discovery process.
Traditionally, trading in securities had been executed in pits as a central location (Gorham and Singh 2009), with traders exchanging buy and sell orders on their own or on behalf of their clients. In that system, personal interactions bred collusion among unscrupulous traders to front-run their competitors (Schlegel 1993). Front-running refers to an illegal practice of executing orders on a security early with the advance knowledge of pending orders from customers/competitors. Computerisation helped to eliminate front-running, and was better able to handle rising volumes, reduce transaction costs, and improve speed and accuracy. Naturally, the bulk of trade shifted to the online platform. What happened next? To attract volumes amid increasing competition, increased technology support and reduced delays became the fashion for online exchanges the world over.
More from Venkatachalam Shunmugam writing at Voxeu
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