The management and governance of LIFFE is not an easy job. Exchanges are natural monopolies, and provide benefits which are valuable only in what they make possible.
The management and governance of exchange is not an easy job. LIFFE is squabbling over its governance and its ownership, while business in its key contracts is ebbing away. The Treasury Select Committee is only the most vociferous of those who have blasted the London Stock Exchange for the self-serving attitude its members have adopted to its governance. The regulators of the London Metal Exchange have the same concerns about its dominance by ring-dealing members. Not to speak of the problems of the Lloyds insurance market.
Why is running an exchange so difficult? There are two features which distinguish exchanges from most other businesses. First, they are natural monopolies. There are not many exchanges trading any particular stock or contract and rarely more than one in any jurisdiction. Tradepoint’s turnover last year was less than 1% of the London Stock Exchange and the LSE’s business objective is to have 90% of worldwide turnover in UK shares. Usually there is a dominant exchange. Trade flows to the thickest and most liquid market. (I don’t understand how something can be both the most thick and the most liquid at the same time, but these are the metaphors that people use).
This natural monopoly element can make for instability. Only two years ago, LIFFE was dominant in Bund futures. Today it has lost that market dominance to Frankfurt and its market share has fallen by half. Few industrial markets show such fluctuations of fortune. So good management matters.
Second, the benefits from efficient and effective market trading accrue not to the market itself but to the businesses that make use of it. A market is rather like an item of infrastructure – the railway network, the national electricity grid, the judicial system. All of these are natural monopolies whose services are not intrinsically valuable but are necessary to facilitate the provision of services by other people.
And all of these infrastructure activities pose problems of management also. Some are state owned and managed, like the courts – not, as a rule, very efficiently. Some are run by tightly regulated private companies – the grid. And some, like the rail network, have recently moved from one category to the other.
These solutions are less than perfect, but they may well be better than the way exchanges are normally run. Most exchanges came into existence as informal associations of brokers and traders. As their constitutions have been formalised and the competitive environment has become tougher, these structures have been more and more likely to encounter difficulties. Strong managers soon fall foul of stronger interest groups – as with Ian Hay Davison at Lloyds or Michael Lawrence at the Stock Exchange. Weaker managers conciliate these interest groups, allowing problems to accumulate until they reach crisis proportions.
The objective of an exchange should be to maximise the profits arising from the activities of the exchange, which go much wider than the profits of the exchange itself. There are the returns to the skills of the people who work on the exchange – individuals and brokers. Then there are the returns to the companies whose distribution capabilities or client lists bring business to the exchange – typically the major broking firms. And finally there are returns to people who do business which is based on exchange – such as fund managers.
The trouble is that each of these groups wants to maximise its own returns, rather than the sum of all returns. That is why simple privatisation is not the answer, because the owners would be interested in the first of these categories of return – the profits of the exchange – at the expense of others. Of course, the prospect of raising £500m by floating LIFFE would conciliate today’s objectors by handing to them the future as well as the current profits of the exchange. But it is a sensible governance régime only if the owners were to be the people interested in the other categories of return, and there were restrictions on their ability to sell shares to outsiders.
This explains why LIFFE is split. Individuals have specific skills – such as those of the locals who participate in the open outcry system on the trading floor, and they want an opportunity to use them. Companies – often their employers – simply want to maximise the rewards to their business-getting capabilities. The first groups wants change too little, and the second wants it too much.
At first sight, it seems that a good system would give each interest group shares of ownership and votes proportional to their interests in the total. But this falls foul of majority or minority tyranny. If some combination enjoys 50%of the votes, it exerts all the influence (as in a corporation). If you have a higher threshold for agreement, then minorities can extract attention disproportionate to their number (as with the governorship of the European Central Bank).
There is no perfect solution. But we can detect some elements of the right approach. Detach Councils and Governing Boards from day to day – or even month to month – decisions. They will inevitably undermine managerial responsibility and often degenerate into posturing by conflicting interest groups. Give strong managers freedom to develop the business of the exchange, but make sure they are periodically accountable for their success in that. And accountable to a group that includes not only the relevant interest groups, but a strong leavening of objective outsiders. The role of outsiders is less to protect the public interest, although that is relevant, but rather to prevent any interest group exerting too much or too noisy influence. That is how infrastructure assets – from water boards to universities – were generally managed before the state took control. And it often worked.