You better think (think) think about what you're trying to do to me.
-- Aretha Franklin
The world of exchange trading is in crisis. The crisis springs from the rapid unveiling of the inadequacy of the SEC's National Market System (NMS). How did we get here and where are we going? The problem is not technical. It's not simply high frequency trading and speed bumps. It's a result of a fundamental flaw in the SEC's regulatory philosophy.
An exchange is what an exchange does. There are three forms of American exchanges: futures exchanges, options exchanges, and stock exchanges - ordered by the weight of the trading returns flowing from each type of exchange to their parent firms. The U.S. futures exchanges are by far the most successful. And better behaved, outside an occasional trader peccadillo. Unlike the badly behaving, quarrelsome, stock exchanges.
Why the difference? It always comes down to upbringing, with kids, doesn't it? Futures exchanges are CFTC regulated; stock and options exchanges, SEC regulated. The SEC is a bad mommy. While the CFTC has been notably open-minded, fostering futures exchange self-reliance by permitting their exchange progeny responsibility for decision-making in the risky environment that fostered the birth of financial futures; the SEC has been over-protective. The outcome is predictable.
So, how do things go wrong? Describing what exchanges do once was simple. Not so simple, these days.
The way we were.
Exchange function was not always complicated. The answers in prehistoric times before computers made exchange decisions tougher:
- Exchanges provided a place to trade.
- Exchanges limited access to each trading venue to members only.
The members took responsibility for the business of exchanges - trades, themselves - which are inevitably split into two parts:
- Transactions: record and confirm trades.
- Clearing: settle counterparty obligations.
As might be imagined, the members choose to organize, basically to assure quality - financial and character - of new members, to establish fiduciary rules to prevent trades from failing, to resolve disputes, and to discipline membership. Easy peasy. Exchanges didn't see themselves as sources of profit. They were more like neighborhood meeting centers.
The war for financial futures: Chicago vs. New York.
In the good old days, stock exchanges based in New York were dominant. Chicago exchanges were viewed as off-Broadway, at best; hoodlums, at worst. A comment from a New York investment firm executive about the quality of Chicago exchange management circa 1980 summarized the New York attitude nicely. "My God! These Chicago guys wear plaid vests!"
But the reality of Chicago leadership was substantial. Leaders rose up through the rough-and-tumble and discipline of the trading floor. Not born to wealth, the success of their particular exchange was everything to them. They knew success would be driven by their willingness to take risky action. There was a fight for the financial futures turf brewing with New York, and Chicago traders expected to win it on the merits of their decisions.
Chicago feared one thing. The ability of New York to enlist Washington - in particular, the SEC - to preserve New York dominance. So, the Chicago strategy was clear. Innovate, but avoid SEC-regulated markets for common shares.
How the markets changed.
Chicago's opportunity to explode to prominence began with two sudden changes in the trading environment that radically altered the ease of performing exchange functions and increased the importance of exchange protection of markets from risk:
- A series of economic events circa 1970, most prominently the end of Bretton Woods' fixed exchange rates and the onset of the OPEC crisis, made the business world a dramatically riskier place. Raw meat for the futures exchanges, since the risks were affecting fallow trading ground outside SEC jurisdiction: foreign exchange prices, Treasury and bank interest rates, and energy prices.
- The cost of electronic trading functions began to fall dramatically. This affected everyone, although the futures exchanges seized the opportunity first.
The resulting reversal of fortune of futures exchanges is a classic story of how character of management and regulatory philosophy drive successful - and not-so-successful - response to crisis.
Chicago's futures exchanges manage their own risks. Futures exchanges have always been better adapted to manage risk than securities exchanges. Characteristically, futures exchanges use a self-determined, self-administered, risk management system, including their own individual clearing houses. Off-exchange trading is prohibited.
Securities exchanges do the other thing. They ask mommy what to do. They are given rules by the Fed for risk management decisions. Guess which system is more thrifty with customer margins, yet less exposed to trading defaults.
Chicago's futures exchanges embrace change. Futures industry management was aggressive. Most of the credit for this goes to CME Group (NASDAQ:CME), as have most of the spoils. The CME's two flagship financial futures markets, Eurodollar futures and S&P futures, are, 35 years after their introduction, still the globe's two most successful. The CME was the first to introduce electronic trading.
Somewhere along the way, CME's leadership decided the membership deserved to get rich for their creative efforts. Thus, the CME was the first exchange to demutualize to go public. CME stock has outperformed the overall stock market by a wide margin since.
The permissive CFTC opens the new market door. The futures regulatory agency, the CFTC, displayed an unusually open mind, for a Washington regulator, about the entry of the futures exchanges into new markets. It was clear from the outset that the CFTC saw its future in regulation of a much broader range of financial and commodity futures.
The SEC had no grounds for a claim of jurisdiction over financial futures on financial instruments other than common shares. But there was substantial press opposition to financial futures and some push-back from the Fed as well. Ultimately, I suspect the behind-the-scenes support of University of Chicago economist Milton Friedman and of other corporate and government leaders was significant in the positive outcome for Chicago.
New York's managements' defensive posture. The NYSE countered Chicago's advance by creating a new futures trading subsidiary, New York Futures Exchange (NYFE). The new futures exchange was a blunder that is emblematic of the stock exchanges' mistaken notion of the path to ultimate success. The New York exchanges relied on prestige and the Washington connection.
NYFE misjudged the fundamental determinate of futures exchanges' success. Chicago's success is a product of the commitment, skill, and marketing prowess of Chicago traders, trading firms, and leadership. A smart New York move would have been to recruit key traders. Instead they recruited Chicago exchange staff, thinking - I don't know what.
New York's cozy relationship with Washington. NYFE's ace of spades - it mistakenly believed - was its Washington connection. The Fed "encouraged" the CME to avoid direct competition with new NYFE listings. The CME rejected this, resulting in a CFTC lawsuit to enjoin the CME to delist its NYFE-competing contracts. The CME won the suit. Two years later, NYFE was an historical footnote.
The futures-securities environments forged in the competitive fire.
The outcome of this struggle was two distinct industries with different philosophies. The futures industry has, thorough the force of its success and its contribution to the success of its regulator, created an environment of cooperation with the CFTC.
The deadly SEC box. The future of the stock exchanges is far more problematic. By feeding into the SEC's basic modus operandi, protection and expansion of its dominion of ever-multiplying, redundant, securities exchanges, the older stock exchanges (NYSE Group's three exchanges; the Bats exchanges, recently acquired by CBOE Holdings; and Nasdaq Inc) have become parasites.
The parasite exchanges thrive, in large part, through an elaborate game of "pass the trash," spawned by the SEC's National Market System.
How NMS "works?"
First, exchanges pay fees to brokers in exchange for resting orders (many of which are pulled before they are filled - a better name might be restless orders). The exchanges' purpose in paying for these apparently worthless restless orders is that, ridiculously, this purchased fake data is marked up and sold back to those broker-dealers that "want" the data in a hurry. And broker-dealers seriously "want" the data in a hurry. Their survival in competition with other brokers depends upon it.
So, follow the bouncing ball. In the brave new SEC world, a dealer creates data by placing resting orders that are never filled. The dealer is paid to create this data by an exchange that doesn't anticipate generating trades or trading fees from these resting orders. The exchange does expect to profit by selling back the prices of these never-to-be-filled resting orders to the same brokers that sold the data to them, at a profit.
So, I ask, which system has the brighter future, the stock exchanges or the futures exchanges? To generate the breakout growth that comes with a real change in the trading paradigm, any innovating exchange must steer clear of the SEC.
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.