As the London Metal Exchange demutualises after 400 years, we must be alive to the systemic risks of demutualisation - a harbinger of financial cataclysm.
There is enough evidence from the double crisis of the last five years that demutualisation is a good predictor of future financial instability.
Investment banks all sold out of their partnerships and used the increased capital to massively boost leverage, a problem still unresolved; UK building societies demutualised, lent aggressively and disappeared in the bonfire of ex-building societies in 2007/8, while the remaining building society sector didn’t take public money in the first crash of 2008.
So as we watch the London Metal Exchange’s completion of a drawn-out demutualisation in a sale to the Hong Kong exchange, we have to question how mired the City of London remains in this evidence-free dogma of demutualisation.
This is despite the fact that exchanges are perhaps the best example of markets being social.
Most of the large exchanges were mutual, including the LME for at least four hundred years (the oldest, the Amsterdam Stock Exchange, was set up in 1606 and demutualised in 1997). “Producers of liquidity” – if I can call them that – came together in exchanges to provide prices on assets to allow people to buy and sell commodities, stocks, shares and so on.
The tacit knowledge accrued over that time has meant that they had a data set exceeding any other which allowed them to successfully price risk, especially the price for leverage, over the cycle.
This was of huge value both to them and to the health of the market, benefiting the consumers of the liquidity: it is something that demutualisation has steadily degraded.
The “consumers of liquidity” – then private investors, now our pension and insurance funds – benefitted hugely from these mutually owned exchanges.
However, with the convergence of the information revolution and neoliberal economics in financial markets, technology made the exchanges appear more like technology companies than the very human coloured-jacket-clad shouting brokers in futures pits.
The brokers’ bosses, who collectively owned the exchanges, decided they would be better off to demutualise them. The thinking ran as follows: given that trading would congregate to the best price, and because they could connect the consumers of liquidity to their each broker’s proprietary network, the producers of liquidity no longer needed to come together in a mutually-owned exchange.
It was better to monetise the value of the existing network by selling off the stock exchange to private shareholders, and invest the proceeds in their own proprietary exchange – the free market at its best.
Yet a decade on, the consumers of liquidity are increasingly becoming concerned about the fragmentation and instability of the new way of trading.
Because the major exchanges are profit seeking, and increase their profits by increasing turnover, this pushes them to increase turnover by allowing trades at nano-second speed. As a result, High Frequency Traders (HFT) now account for 60% of trading, exploiting rather than facilitating a functioning market.
This is now having a systemic risk effect: it was HFTs that were behind the flash crash of the stock exchanges a year ago.
Within the demutualisation dogma, this is all sidelined as a regulatory problem. Yet the failure is one of the consumers of liquidity’s collective imagination: they seem unable to conceive that a mutual structure would allow them to use their buying power to achieve their desired market structure with limited high frequency trading.
Mutuals are hugely successful when the free market is failing to provide for a clear need. Unfortunately that is a glaring need now that exchanges have failed as private entities.
As the flash crash showed last year, this is now a problem for regulators, particularly as regulators are now insisting on the use of these exchanges as Central Clearing Counterparties. But rather than greater regulation, regulators need to push back on investors in the City and Wall Street to remember the evidence of the failure of the dogma of demutualisation.
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