On the quarter-centenary of the stock market’s modernisation Tullett Prebon chief executive Terry Smith explains what went wrong
Thursday 27th October is the 25th anniversary of Big Bang. On this day in 1986 the way in which shares were traded in the UK was changed. In particular, there were no longer any fixed commissions for share trading and brokers and market makers were allowed to combine in so-called dual capacity firms.
The background to this was that shares had been traded on the London Stock Exchange which was literally a mutually owned private members club. The members were firms – brokers who dealt with investors and who charged commissions for doing so and jobbers or market makers who provided liquidity for dealing and in return took a spread between the buying and selling price – the bid-offer spread; and the individuals who were principals of those firms, most of which operated as partnerships.
Prior to Big Bang commissions on dealing were fixed: all brokers charged the same rate of commission and did not compete. Investors could therefore not shop around and get the best deal. But at least investors were protected in the sense that the brokers’ relationship with the jobbers was an adversarial one – the broker would try to get the best price obtainable from the jobber when dealing.
This structure had made London increasingly uncompetitive as a venue for share trading, particularly when compared with New York which had its own version of Big Bang, known as May Day as it happened on 1st May 1975 when it scrapped fixed commissions. Trading in large international company shares had begun to migrate to New York because investors could deal more cheaply there.
The Big Bang reforms were negotiated between Trade Secretary Cecil Parkinson and Sir Nicholas Goodison the Chairman of the Stock Exchange.
At Big Bang I was working for the newly formed BZW which Barclays Bank had assembled by acquiring the broker De Zoete & Bevan and the jobber Wedd Durlacher. I was running the Financials desk which analysed and dealt in the shares of banks, insurance companies and property companies. Ironically, I was analysing many of the companies which took part in Big Bang.
Big Bang not only changed commission and allowed brokers and jobbers to combine. At Big Bang we also went from a world in which:
- People came into work at 9.30am, went for a long, often liquid lunch, and left at 4.30pm to one in which work started at 7am and lunch became something you ate at your desk.
- Client orders were done by a dealer on the Stock Exchange floor to one where share prices were displayed on screens and dealing required only the click of a mouse as the electronic order book replaced the Stock Exchange floor.
- Firms dealing in shares were mostly partnerships to one in which they were mostly owned by foreign banks.
In my view Big Bang was a colossal mistake. The basic motivation for it was correct. Fixed commissions were a barrier to competition and London was losing out as a centre for share trading as a result. But Parkinson and Goodison made an incorrect assumption. They correctly foresaw that an end to fixed commissions would lead to a radical cut in commission rates. But they went on to reason that this fall in commission rates would render stockbroking unprofitable. As a result they accepted a quid pro quo that brokers should be allowed to combine with jobbers (to use the jargon, they should switch from being single capacity firms which either did broking or jobbing to dual capacity firms which did both).
This assumption ignored a simple law of economics-elasticity of demand. They failed to recognise that the reduction in commissions would lead to an upsurge in the volume of shares traded.
These Big Bang changes also introduced insuperable conflicts of interest. No longer were investors protected by a broker acting as their agent and trying to get them the best price. Instead they were dealing with integrated firms which maximised profits by giving investors the worst deal they could as they were principals on the other side of every transaction. And these were not the only conflicts of interest which arose from Big Bang. Integrated securities businesses also provided Merger & Acquisition advice to companies – formerly the domain of merchant banks – as well as providing research on those companies’ shares for investors in those shares, trading in those shares as principals and raising equity or lending money to fund the deals. The potential for profit at the expense of investors as a result were manifold.
These conflicts are supposedly policed by so-called Chinese Walls which keep these functions separate within banks but the long line of scandals on both sides of the Atlantic in the securities markets over the past two decades show that this has unsurprisingly proven to be ineffective. A regulatory concept like Chinese Walls is no match for greed.
It may seem inconceivable that any of the Big Bang reforms will ever be repealed but until they are I think we will be condemned to suffer the sort of mistakes, malpractice and calamities which helped to cause the current financial crisis.
I have changed my mind about Big Bang as a result of the events of the Credit Crisis. As John Maynard Keynes famously remarked: “When the facts change, I change my mind.”
Terry Smith is chief executive of Tullett Prebon and Fundsmith.