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Why does the performance of securities exchanges lag while that of futures exchanges goes from strength to strength? Otherwise put, Why is the CME Group (NASDAQ:CME) standing pat as The LSE (LSE:LON) (OTCPK:LNSTY) and BATS (BATS:BATS) are put into play?
Because the market for retail securities is broken. How will market forces drive the future of exchange trading? Will government regulators like the SEC stand in the way of progress?
The old-fashioned law governing transactions in my focus securities here in SA - to wit, trades of shares and derivatives - is out of date. We need to change it. The most likely source of change is a competitive war between the CME, or a start-up, and the acquisitive Intercontinental Exchange, Inc. (NYSE:ICE).
This article focuses upon inefficiencies due to lagging adaptation to technology in our surprisingly successful securities markets. Changes would make this market more reliable and brokerage cheaper, if the baby isn't thrown out with the bath water.
Rid the market of its parasites; replace them with servants of the market. We need to remove the parasites feeding on retail securities traders. And we need to rid the markets of inefficiencies created by these parasites. But the attitude of the securities exchanges, for the most part, is: "How can I feed off this market?" This article focuses on the lagging technology resulting from the ubiquity of these government-created jackals. It suggests unexpected change for the better may be imminent.
The way forward is for a dynamic, risk-taking exchange management firm to swallow the parasites - changing their lagging trading tech.
How can we create efficient securities markets? The opening shot in this drama was fired by newly-created IEX, the darling of the buy-side. But is the CBOE (NASDAQ:CBOE) acquisition of BATS just an attempt to cut cost? Or is it another step into the trading future?
The CBOE floor.
The experience of IEX, an exchange that eschews the abuses of the other securities exchanges, is revealing - since its exchange designation. The IEX experience shows us just how difficult it will be to replace the parasite exchanges with better alternatives thorough market competition between stock exchanges.
The big players in securities markets have become accustomed to the messy, inefficient, set of costs assessed, and rewards paid, to traders by the 12 other securities exchanges. There may be a consensus that the system is broken, but insufficient agreement to fix it through market-based decisions.
What do securities markets need? The markets need to drive toward more efficiency, for two reasons - safety and cost. One key is contract immutability. The social value of immutability in securities trading is enormous. Without it, ownership becomes uncertain. In the U.S., which prides itself on the sanctity of property rights, doubt about ownership is destructive of faith in the financial system's very function.
Plainly, in the case of securities law, is the sine qua non of market efficiency - "a deal is a deal" in an efficient retail financial market. Thus, the design of a quality financial contract minimizes performance risk and the incidence of recourse to the courts.
In other words, quality financial deals necessarily focus on: their extreme frequency; the large population of participants; and the fact that financial deals usually have a loser, who will regret making the deal. A key property of financial transactions is that, despite the daily displeasure of losers, deals must be very difficult to cancel or litigate.
The goal - bullet-proofing the deal. Financial contracts, particularly those of interest here on SA, are meant to be entered frequently with counterparties with whom the trader is unacquainted - this expands the circle of available counterparties, improving the price. Yet performance of anonymous counterparties must also be beyond doubt.
And since ownership of financial assets involves the fundamental principle of capitalism, that ownership is evidence of belief in profitability; in this uncertain, ever-changing world, transfer of ownership must be cheap, since it's bound to be frequent.
How well do exchange-traded securities transactions technologies in the U.S. marketplace promote immutability? And how do they affect the cost of a trade? There are three basic methods by which financial contract performance is assured; legal challenges, made difficult:
- Simplicity and predictability. Contracting should be straight-forward. Customer/broker/exchange/broker/customer. Each performs a function essential to the customer, and to market stability - or did, once upon a time.
- Collateral. The probability of failure of my counterparty to pay me must be small; its consequences, grave. Collateral simultaneously reduces the likelihood of failure while reminding parties to the transaction that the probability of loss is substantial.
- Settlement speed. Collateral wastes. Losses increase with delay. While ownership of collateral is in doubt, the possibility of litigation multiplies.
- Absence of free riders. Free riders are unnecessary third parties who grab a piece of the value created by U.S. domination of securities trading without providing value by improving trading efficiency. A trader should not find herself part of a chain of unknown counterparties with motives opposed to hers.
How do the contracts of U.S. retail transactions markets stand up to these standards?
Trading technologies typically have two components: transactions and clearing. I see no reason why the two dominant trading technologies, futures and options trading, and securities trading, are not on par - identical in the success with which they meet the criteria above.
- Before 1992, when the CME Group (then the Chicago Mercantile Exchange) introduced electronic trading, the first bottleneck was the need to compete orders through human traders on the floor of an exchange. The CME's Globex trading platform eliminated that bottleneck. Electronic trading is now universal in the U.S. at the retail transaction level. It is interesting that this advance in efficiency emanated from a futures markets, already more efficient than the securities markets.
- The second bottleneck is the exchange of value as market prices change. Futures markets are, again, more effective.
- Futures markets. In futures markets changes of value in a futures position are paid to winners by losers, through the exchange clearing house, at least once daily.
- Securities markets. The DTCC nets each securities firm's purchases and sales, for each security, during the trading day. Transfer of net securities purchases and cash is electronic, three days later.
Simplicity and predictability. Futures tech is more simple and predictable. Futures trade processing makes no distinction between transfers between parties that are in the market and those that have entered or exited the market, on any given day. Every trader has all positions marked to market in cash at least daily. Risk of counterparty failure is nil. The exchange has no "skin in the game," so settlement is objective.
The DTCC "considers" counterparty risk once, on the day the trade is entered. The brokers themselves, and their bankers, worry about price risks and the associated credit risk otherwise. Risk of counterparty failure is greater than in futures trading, and hinges on the individual brokers and their bankers, each of whom manages this risk separately. The brokers and their bankers both have "skin in the game," so there is an undesirable incentive to "shave" prices.
Collateral. The efficiency advantage in collateral again goes to futures. Collateral is a cost. The lower is collateral for a given price risk, the cheaper it is to trade a market. Futures exchanges set collateral requirements themselves, typically by considering the risk that the price of the contract being margined will change during the trading day. Securities markets collateral is set by a Fed edict that has not changed since the Depression, at half the value of the security being margined - far higher than futures margins. Unlike futures, neither the exchange nor the clearing house is involved in margin collection.
Settlement speed. Advantage futures. Futures settlement is daily, by the exchange, at market prices. Securities settlement happens once, with a three-day delay. This advantage to futures is the result of historical competition between the various futures exchanges' individual clearing houses. They did not have the luxury of the monopoly position of the DTCC - thus there is no T+3 in futures markets.
Free riders. Advantage futures. Futures exchanges are not free riders. Not regulated by the SEC, the futures markets do not have 12 exchanges trading every futures contract. That system exists only in the securities market, a consequence of the SEC's poorly conceived National Market System.
In futures, competition drives every market to the single, most liquid, exchange. Hence there are no fees charged to "liquidity-takers," no payments to "liquidity users," no collocated computers that pay for that privilege, and thus no need for an IEX "speed bump" to slow down high frequency trades.
The possible market outcome. Clearly futures are the more efficient. How long until futures markets figure out that it is not "trading for future delivery" that makes futures exchanges more profitable than stock exchanges? It is that futures exchanges are safer and cheaper than stock exchanges. Futures exchanges won't be futures exchanges soon. The only open question is which exchange will "get it" first. Fifteen years ago, I would have picked the CME, hands down. Today, the CME seems to run out of its innovative steam. Perhaps a startup, akin to IEX but more aggressive, will step in.
But then, the internecine rivalry between futures and securities market regulators must be dealt with, as well as the predictable horror of the dealer banks.
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.