Wanted to be near you.
But (of course) somebody owns you now.
Consider the future of IEX, our newest SEC-designated stock exchange. Born in controversy, IEX faces many limitations in the short run. Just the technological barriers -- hooking up the data feeds that the SEC requires broker-dealers to acquire from each exchange -- will take several months. IEX is further hobbled, certainly in the next year, by limiting itself to trading of common stock. But in a recent interview, Brad Katsuyama, CEO of IEX, signaled the start of Round Two, here.
Round Two will be a fight over what the other exchanges will call IEX's unfair -- or in the words of ICE (NYSE:ICE) CEO Jeffrey Sprecher -- "un-American" giving away of its real-time data feeds. This will raise the question Katsuyama anticipated in his interview. Whose data is it, the exchanges's or their customers?
Who will ultimately win this fight -- IEX or the other exchanges? From a longer-term point of view, IEX has a competitive advantage in each exchange war -- its buy-side ownership. IEX's appeal to the buy-side leaves plenty of scope for the chasing of future opportunities of all kinds that benefit the buy-side particularly. For this, and several other reasons, it is interesting to chart the possible future corporate strategies of IEX, and to compare the possibilities to the existing strategies of the existing major trading, clearing, and financial data service corporations, all dominated by the sell-side.
The bottom line is going to be very simple. The identity of ownership will decide the winner.
IEX, the Adventure Story.
IEX, in the minds of many, is a financial adventure story. The story began with a prequel, "Flash Boys," by Michael Lewis, that created a furor within the trading community. Flash Boys is the story of Brad Katsuyama's odyssey from a job as a broker for the buy-side at Royal Bank of Canada (NYSE:RBC) to leader of IEX, a newly SEC-created exchange.
The story centers on the "speed bump" debate. The speed bump is a length of fiber-optic cable that slows the arrival of orders to IEX's execution engine, eliminating HFT's ability to "race the tape." The speed bump counters the other major exchanges' practice of giving early access to their exchange feeds to high frequency traders (HFT), selling HFTs' computer locations beside exchanges' servers (co-location). This co-location provides HFT traders with the ability to change their resting orders before an ordinary order can be filled (known as "bait and switch"), taking advantage of HFTs' advance awareness of other orders as they are placed, giving them the opportunity to "pick off" incoming orders by fading their own resting orders. HFTs then profit by increasing the price of stocks purchased by ordinary traders. This ability, which is within the SEC's rules, but seems to some to be a bit exploitative (the word "rigged" comes up in discussions), does not exist at IEX because of the speed bump. In the public mind this story ended with IEX's SEC approval.
But apparently IEX's story has only begun. With no public fanfare, IEX has been publishing its data feed in "real time" (without exchange-created delay). You can receive it yourself, here.
The Bigger Picture.
But look at this IEX story through a wider lens. In the bigger picture, the story of IEX is the actually the story of the first significant reaction to a sudden, poorly considered, shift in our global sense of the purpose of markets.
Markets, once viewed by the world as semi-public utilities responsible for the process of trade execution, clearing, and data provision (in other words, glorified coffee houses) have gradually become a collection of publicly held businesses issuing securities that are themselves listed and cleared.
In finance textbooks, exchanges are places where two kinds of trading, securities trading and futures trading, occur. Exchanges are explained in texts as the result of the organic growth of Jonathan's Coffee House in London, and the buttonwood tree where traders gathered in Manhattan. They are normally not seriously scrutinized by governments until a crisis (like the Great Depression) happens -- when everything financial is seriously scrutinized.
The transition from public utility-like behavior began with post-trade clearing in the securities industry by what has become the Depository Trust and Clearing Corporation (OTC:DTCC) and its predecessors, which have provided back-end clearing services for the securities exchanges. In 1970 when the DTCC began to clear American Stock Exchange transactions as well as New York Stock Exchange transactions, a fundamental difference between the structure of competition in securities trading and in futures and derivatives trading industries was born.
Securities are traded in many venues and cleared primarily by the DTCC; commodity exchanges, in contrast, each have their own clearing house. The DTCC is user-owned, leaving it without significant competition, and is thus not a particularly controversial company. In other words, the corporate structure of DTCC is more a convenience than an attempt to generate profits. It has reduced the potential monopoly profits of stock exchanges, relative to futures exchanges, because futures exchanges can compete on clearing services as well as execution.
However, the second important demutualization, that of exchanges, has proven far more controversial than expected. It began, as did most innovations in trading during the 30 years before the turn of the century, at the Chicago Mercantile Exchange in 2000. This exchange -- a predecessor to the CME Group (NASDAQ:CME), by far the largest corporate futures trading operation -- made a more radical change. Publicly held CME Group has a responsibility to return profits to its shareholders.
Demutualization has converted exchanges from the glorified financial utilities that I joined in the 1990s to the grasping entrepreneurial oligopolies they have become. ICE and CME Group, the two largest, are a study in contrasting visions of what exchange management firms are about.
Thus they carry conflicting messages of the future path available to IEX.
CME Group does exactly what the identifier "exchange management firm" implies. Specifically, it manages futures exchanges. This narrowly defined function that CME chose includes provision of trade execution, trade clearing and release of transactions price information. Nothing beyond that -- outside a somewhat unsuccessful foray into clearing of OTC derivatives, largely at the behest of the government following the passage of the Dodd Frank Act. The futures exchanges it does manage, however, are the largest by far.
By all appearances, that is CME's limited vision of itself. The exchange plans to define its success by what happens to futures markets. Although this strategy lacks imagination, it is hard to see it as a losing strategy. The futures exchange industry is considerably better protected from competition than the securities exchanges due to the futures exchanges' captive clearing houses. And the CME's government-motivated foray into OTC clearing may have been enlightening to the CME in a negative way. Perhaps there is a down side to clearing OTC instruments, from the CME point of view. Certainly there was no interest on their part in chasing LCH:Clearnet, the dominant OTC derivatives clearing house, when LCH:Clearnet was put into play recently, due to a planned merger with Deutsche Boerse.
ICE, on the other hand, sees itself as provider of a broader spectrum of services. Any monopoly resulting from transactions is interesting to ICE. It has perceived opportunity in the consolidation of common stock trading with futures trading, most prominently by acquiring the New York Stock Exchange.
ICE has obviously seen the light. It is no longer only an exchange firm, but has become a market data provider through several astute moves, such as becoming the sole source of LIBOR and all the related rates, like EURIBOR, supplied through polls of designated bank "providers;" specializing in futures contracts that settle at prices that are determined at index levels; and through its recent acquisition of Interactive Data Corporation, ICE has taken the lead in exploiting the strange idea that this data belongs to them. In the first quarter of 2016, 41% of the revenues of ICE came from sales of data.
Which Exchanges Will Survive this Struggle?
Trading and clearing of a single security or futures contract are arguably both inherently monopoly activities. This is an argument for substantially greater regulation than these, not surprisingly, highly profitable companies actually experience.
Consider trading for example. It is obviously desirable for any order to "see" the resting orders throughout the market upon execution. This desire is frustrated by the fragmentation of exchanges. It was the SEC's mistaken notion, when the "Regulation National Market System" was created in 2005, that the SEC could simultaneously provide traders with a market-wide "look" while permitting competition between different exchanges that list the same commodity for trading. What was in fact created was a pair of oligopoly rents for the exchanges: the sale of the exchange data feeds and the sale of co-location, to broker-dealers and other users.
Owing to the domination of the old exchanges by broker-dealers, you can be certain that these particular exchange customers got their money's worth from things they buy from exchanges. It is retail and the buy-side that are paying for services that, as Katsuyama points out, are actually provided by traders, not exchanges: orders and price quotations.
But the struggle has only begun. The greater issue that stirred the other exchanges' ire from the outset is that IEX is owned by the buy-side, primarily. In contrast, the ownership of the other exchanges is dominated by the sell-side. And there are many issues that separate the sell-side from the buy-side. These issues will determine the survivors.
The reality, well understood by market insiders, is that the exchanges, data providers, clearers, and others engaged in this struggle are in a battle to the death. Consider the forces at work. Are all these middle-men in order processing likely to be more successful if they are owned by the buy-side, or alternatively, if they are owned by the sell-side?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.