Change is a powerful thing. People are powerful beings. Find the power to be faithful.
-- Lana Del Rey
The great myth of securities trading is that the electronic communication revolution has breathed a new spirit of competition into securities trading. In fact, as the cost of placing and executing orders has come down, far more of the savings have passed into the hands of old-line broker-dealers and exchanges than would have in openly competitive markets. Largely through regulatory capture of the SEC, the Fed, and the Bank of England, gains from technology have flowed into ad hoc oligopolies formed to hoard the windfall, not to the investor.
The natural rise of the great new innovators in other industries: computers, [Microsoft (MSFT) Apple (AAPL)] IT, [Cisco (CSCO), Alphabet (GOOGL), Facebook (FB)] retail delivery of goods and services, Amazon (AMZN), and telephony [Verizon(VZ), T-Mobile (TMUS), Sprint (S)] was stifled in financial markets, with the help of financial regulation and government-protection.
The ultimate result was technologically backward financial oligopolies in the US and UK.
The barriers to the financial innovations needed to clean up the financial institutions that use their government-sustained oligopoly to abuse investors and businesses in placing transactions are two:
- First, the greed and complacency of financial institutions. Not changing anytime soon. Also, not unique to financial markets. The other markets are run by greedy people too.
- Second, corporate capture of regulators; the under-the-table offer, to compliant regulators, of regulatory turf in exchange for regulatory protection of oligopoly rent.
The SEC will need to be put back in its box if American market participants are going to throw off the yoke of government-created parasitic oligopolies such as the cooperating big dealer banks that control wholesale OTC markets like LIBOR, and the amazing bloated American stock exchange management firms, which have created superfluous gluttonous exchanges -- numbering 14 at last count (where one would do the job better).
To address even bigger problems in the wholesale OTC markets. The Bank of England will need to find a way to reform OTC markets without sacrificing The City’s fragile position as a rival to Wall Street.
Breaking the SEC
How to prevent a grasping regulator from helping old-line firms siphon off the benefits to customers of technological change? There are four strategies that come to mind for breaking the SEC. All strategies require an alpha market participant, which must introduce an instrument that is arguably not within the existing rules establishing market jurisdiction. Only the CME Group (NASDAQ:CME) has successfully done so since 1970. The three real innovations in trading technology since then – financial futures, electronic transactions, and demutualization – were all introduced by the CME.
To free financial markets to innovate, regulators must be distracted from their usual instinct to hand the technology’s profits to the regulators’ existing industry benefactor clientele. One regulator must be given a reason to invade another’s turf, and an excuse for it. Strategies for regulatory change:
- Listing an existing security in a new venue. CBOE Holdings (CBOE) tried that in the 1970s, listing options on single stocks in previously nonexistent exchanges. The SEC snapped these markets up. And showed the world immediately that this strategy is doomed to failure. (In an alternative version of this tale of woe, the CBOE lacked strategic thinking.) The SEC created an oligopoly in the exchange-traded options market by bequeathing options franchises to individual obscure exchanges, using the SEC’s favorite non-sequitur, that multiple exchanges create competition. But reality sometimes intervenes. Market cost pressures have forced the options exchanges to merge with the markets for their underlying deliverable instruments.
- Innovate within an existing firm by introducing a different way of trading an old security internally. This will not run afoul of the regulators, so long as reasonable transparency exists. This innovating firm will need to convince users that the introducing firm is an honest broker. The history of dark pools, the most prominent case, is spotty in this regard.
- Create a new exchange to trade a new instrument. Something like streaking at the Super Bowl. You might get attention, but as a long-term strategy, it is unproven. The closest cousin to this strategy is IEX, which created a new market, but accepted SEC regulation from the outset, choosing to break SEC resistance to their innovation.
- Partner with an old exchange. The model for this was the CME’s International Money Market, where financial futures were born.
Why break the SEC?
It all boils down to the SEC’s penchant for using its investor protection shibboleth to disguise it intention to give only lip service to competition between financial institutions. Let’s first look not at the forest but at the trees. It is important to understand the specifics of the SEC’s damaging regulations, since that is what the press, market participants, and the SEC will discuss.
In the American stock market, there are two ways in which the SEC hampers competition at traders' expense.
- The SEC has converted exchange management firms in the American stock market [Intercontinental Exchange (ICE), Nasdaq (NDAQ), CBOE] into parasites. Before demutualization, the exchanges were accused of being the broker-dealers’ toadies (with some justice) but since demutualization the SEC has changed that – for the worse. The SEC’s disastrous National Market System (NMS) created incentives for the exchange management firms to merge on one hand, while spinning off multiple exchanges trading the same financial instruments in the same ways on the other.
- Through the creation of the NMS, the SEC has opened the door to a torrent of wasteful fees and rebates, where broker-dealers and exchanges scratch the itch resulting from NMS-created arbitrage opportunities. By requiring broker-dealers to place orders in the market with the best quote at the time of the fill, NMS opened the door for exchanges to charge for faster access to their order books than that made available through the SEC. NMS has the effect of forcing all broker-dealers to acquire, directly or indirectly, each exchange’s “premium” fast feed. The result of the NMS is that the “best price” available at the time of the trade is almost certain not to be the version blessed by the SEC.
Looking at the trees as above is important, since a look at the trees shows that they shouldn’t be there. But for real change to be possible, it is more important to ask about the forest. If financial markets and institutions are different from vital markets like computer markets and manufacturers, what must be done? Retrospectively, the best thing that has happened to financial markets since 1970 has been the introduction of a competing regulator, the CFTC. If a new financial market, demanding a separate new regulator, were to spring up, how much better off would the system be?
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.