Exchanges are essential to the functioning of financial markets.
The banks and other financial institutions get more legislative and press attention than the exchange management firms, but exchanges are like transportation systems. You don't think about transportation systems until they stop doing a competent job of getting you from one place to another.
What are the benefits and risks to individuals of investing in the exchange management firms such as CME and ICE? The stockholders of these firms live in a beautiful dream. As the chart below displays, there is an apparent level of safety and excess return that few firms can match.
As did Marie Antoinette, the exchange management companies have a life of bliss, yet a certain down-side vulnerability.
Although they have diversified across markets through inter-exchange mergers, each of them is dependent on the success of a relatively few enterprises. And historically, these enterprises - specific market technologies, like trading over the telephone to a single physical location; and specific futures markets, like the Treasury bill futures market - can vanish into thin air.
For example, the new exchange, IEX, may present an existential threat to the newly listed exchange, BATS Global Markets (:BATSBATS), and to the NYSE subsidiary of ICE. While such competition has demonstrably benefited investors over the long haul, there is an issue of potential sudden market failure that has received increased attention recently, as for example in the "flash crash," a sudden drop in stock prices that quickly reversed itself on August 24, 2015.
If the financial marketplace is essential to the day-to-day success of our economy, it is potentially what economists call an externality. An externality is a good or service which, if not produced at minimal quality, costs the economy more in terms of lost production in other markets than the cost of subsidizing the externality. Think of public utilities like police and roads.
Once the exchanges behaved like utilities. With the move from membership organizations to corporations, the exchanges should be thought of as utilities no more. Now that the exchange management firms are corporations, they focus first on their stockholders, not their users.
Yet as a result of their essential function, they have the SEC and CFTC walking on eggs. They are among the few corporations on the globe that might, through their own mishaps or mistakes, affect every stock in the marketplace for a substantial period of time.
These companies may have become too profitable and too safe. They may have, through complacency, become both less creative and less reliable in recent years. It would be good to release the market regulators, the SEC and the CFTC, from any need to assure the survival of these entrepreneurial exchange corporations.
Set the SEC Free.
What is needed is an insurance policy of sorts for traders, so that the SEC and CFTC can discharge their obligation to the public without protecting exchanges that don't need or deserve it. Create another securities market where reliability comes first and profitability second.
This would benefit the competing corporate exchanges as well as the trading public by reducing the pressure the regulators place on the exchanges to meet the needs all market users simultaneously.
This would minimize government interference in for-profit exchange competition, while meeting the needs of the traders these exchanges are presently ignoring.
There is always something to be gained as the corporate exchange management firms slug it out with each other and their coming new competition, exchange managers such as the Investors Exchange (IEX, Private) that may soon be having the existing exchanges for lunch.
But let us also have one or more not-for-profit exchange utilities where a boring simple computer provides the simplest way of providing traditional order fills consistent with the SEC's NMS rule requiring routing of orders to the best current price. This exchange utility, a sort of market version of the Post Office, would service investor orders in an unprofitable way that investors might use at cost, possibly subsidized by the for-profit exchanges, which have clearly deserted any thought of serving these customers even-handedly.
What has incorporation of exchanges done to the behavior of exchanges?
Along with incorporation has come consolidation. And with consolidation, a dilution of the accountability of individual exchanges. Does declining accountability outweigh the positive of a better business model for pursuit of exchange profit and reduction of exchange risk?
There are compelling reasons, financially, for exchange consolidation that outweigh, for any well-managed exchange management corporation itself, public accountability.
- First, the computer engines that execute customer transactions at exchanges are subject to considerable economies of scale. A related fact is that the industry of price dissemination, when housed inside the exchange corporation, should lead to more accurate and more timely price data at lower cost. The provision of data to market participants has become a cost-effective new business line for these companies. The new exchange management corporations are terrific profit engines that mask, for now, the riskiness of their business.
- There are substantial survival risks associated with exchange competition. Some industries, notably automobile manufacturing, and banking, are characterized by long winning and losing streaks, but many survivors. This is not the dominant pattern in exchange trading. A given market, historically, was dominated by a single exchange after a period of violent competition. Diversifying across exchanges and markets by a single corporation is an obvious and reasonable response to this fact.
But in recent decades, the old motive for consolidation, the inherent danger to an exchange of the tendency for trading of a single instrument to concentrate itself within a single dominant marketplace, has changed with two new factors: the advent of electronic trading, and the introduction of the SEC's National Market System.
I have no doubt that retail customers and wholesale dealers trading for the house account are far better served by the system we have today than at any previous time in recorded history.
Yet I find the system less than it could be. Substantially less than it could be. The exchange management firms are not the risk-takers they once were as creators of new product, and they fail to focus on their old bread and butter, the filling of a retail order.
What the existing exchanges do focus upon is anything that will attract more high frequency transactions (HFT). The three most prominent ways in which exchanges compete for HFT customers at other customers' expense are:
- Co-location: the offering of customer computer location on-site, reducing the time it takes to for co-located customers to "see" market prices in comparison to the other customers in the market.
- Purchase of order flow from retail and wholesale brokers.
- Discriminatory fees. Liquidity "providers" are subsidized, liquidity "users" must pay.
- A host of new order types, designed to help HFT customers to gain various advantages over others, have been introduced.
I have no objection, other things equal, to exchanges offering preferential treatment such as this to certain customers, given that the exchanges that do these things make this behavior public knowledge. And they do.
Let's be fair to these exchanges.
To me, the issue is not one of a need for new limitations on exchanges or traders, but one of choice. If, as was once the case, there is only one exchange in the world for each security, one price and system should fit all. But if there are many exchanges selling the same security with different levels of service, the buyer should be able to choose.
And there is the rub. With the National Market System (NYSE:NMS) you don't get to choose your exchange when you look for a security. If you don't want to trade in a particular market, NMS gives you no choice. This should change. If one exchange meets the needs of a particular user better than others, users should be able to indicate a preference, at no additional cost. There should be two possible ways to specify preference. 1. Use Exchange A only. 2. Use Exchange A if the price is as good there as elsewhere.
Once the SEC imposed the requirement to choose the best price with no other qualification upon market participants, the SEC increased the cost of executing a transaction for every participant in the market. And thus they bear sole responsibility for assuring no trader is harmed by the rule. While different types of traders may be presented with a choice by an exchange, no trader should, without her knowledge, become the currency by which an exchange pays another trader for her patronage.
The only way to have it both ways - competition and minimal safety - I believe, is to assure one exchange is outside the competitive game - a non-profit.
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.