Ending Electronic Gluttony: Exchange Management Firms And Electronic Trading

Kurt Dew profile picture
Kurt Dew


  • Common stock exchange management firms have become parasites, increasing user fees by as much as a factor of ten in the last five years.
  • These firms charge fees for SEC-mandated services.
  • The result of SEC-mandated profitability may soon be absurd; many exchanges owned by one exchange management firm.
  • Or a new exchange will innovate, competing in new products and services, replacing these parasites.

Many industry participants accuse the exchange management firms of a conflict of interest, due to their for-profit status. There are two ways to end the serial abuse of stock market participants by the three remaining exchange management firms dominating equities trading: Intercontinental Exchange Inc. (ICE), Nasdaq Inc. (NDAQ), and Chicago Board Options Exchange (CBOE). SEC Commissioner Robert Jackson chronicles this abuse of market participants by exchanges in his inaugural speech here. See also Letter of Healthy Markets Association to Sec. & Exch. Comm'n, Petition to Address Conflicts of Interest, Complexity, and Costs Related to Market Data (Jan. 17, 2018); and U.S. Equity Market Structure Part I: A Review of the Evolution of Today's Equity Market Structure and How We Got Here (June 27, 2017) (testimony of Jeff Brown of Charles Schwab, on Behalf of the Securities Industry and Financial Markets Association (SIFMA)).

  • We could end the abuse by changing SEC regulation.
  • We could end the abuse through exchange innovation, by introducing new exchanges that do more than just make a living off the fees resulting from concentrated volume in existing instruments. Exchanges that improve the instruments themselves would change the psychology of exchange management from parasitic to proactive.

Neither measure bodes well for stock exchange management firm stockholders, although the second choice improves the relative position of shareholders in the innovative firm.

Circa 2000, it was fashionable to say that our financial markets had become as efficient as possible. Brokerage fees and bid-ask spreads were falling across the board, while speed of execution dramatically improved. All the result of replacing phone communication and floor execution with online communication and computerized trade execution. Trade execution went from the speed of voice to the speed of light in less than a decade.

How did the system fail?

The transition of markets from voice trading to electronic trading, which began with the introduction of the internet, promised enormous savings for financial risk managers and other traders. There should have been huge gains in quality of trading services - gains that should have been comparable to similar gains that flowed from the advent of the microcomputer and the internet.

There is reason to believe the potential for more and better marketplace services, following transition to electronic trading, was even greater than the potential of those earlier consumer bonanzas, due to substantial network effects that trading technology had already generated before electronic trading was introduced.

The system failed to achieve its full potential because exchange leadership found it necessary to compensate exchange membership to make the transition from voice trading to electronic trading by changing exchanges' corporate form from non-profit to for-profit status, then exchanging old memberships for new corporate shares. The SEC then multiplied the value of the conversion to for-profit status, designing the national market system (NMS), the SEC's response to electronic trading, to guarantee profitability of any SEC-approved exchange.

The early 21st Century transition of exchanges from mutually held organizations to publicly traded corporations was the inevitable result of the exchanges' transition from voice to computerized trading. Computerized trading took away floor traders' bread and butter, the observation of buy and sell side momentum. Creating an incentive for exchange members to relinquish the advantages of voice trading was one motive for converting exchanges to for-profit status.

A for-profit exchange might replace floor traders' lost personal information advantage with direct benefits of owning shares in newly formed exchange management companies. Exchange leadership persuaded the members to part with their voice-trading income by replacing it with the capitalized value accruing to the exchange's advantageous position as a whole. Members exchanged their market information advantage for a share of the profits of the (now for-profit) exchanges. The logical expectation was that the floor traders' information advantage would accrue to the exchanges, in the form of an exchange-wide information advantage vis-à-vis the market as a whole.

But predictably, the for-profit exchanges have become market vultures. The exchanges, having identified arbitrage profits of high frequency electronic traders (HFTs) in the years following the transition to electronic trading, have then siphoned these profits away from the HFTs by setting exchange fees for HFT immediate access to prices (colocation fees) at a level that assures that the exchanges, not HFTs, capture the value of speed arbitrage. (See HFT Traders Hit a Speed Bump, Financial Times, 1/1/2018.)

Not surprising, since the old voice trading profit from early knowledge of bids and offers was exactly what the former floor members, now stockholders, lost when they gave up their floor presence.

The complacent exchange management firms.

However, profits from the information advantage possessed by the exchange, as a whole, inspired exchange complacency. In the transition to electronic trading, the exchange leadership never looked beyond collecting exchange fees accruing to their market advantage, to provision of new services. The exchanges tried simply to profit by bumping up the fees for trading and data access.

As a result, the opportunity to enhance exchange profitability by introducing new products that serve transacting customers, modern risk managers, was lost. The new exchange management firms failed to make changes that would unlock the enormous potential for market efficiency improvement enabled by modern financial technology.

The reduction in cost from electronic trading was mostly due to eliminating middlemen on the trading floors and paper pushers in the bowels of the brokerage firms. By cutting out several layers of unnecessary intermediaries, costs of trade execution fell.

The new exchange stockholders benefited nonetheless because exchange fees increased or fell by less.

What did we lose in the transition to for-profit exchanges?

The potentially controversial change, for-profit exchange governance, drew less attention than electronic trading. The public and market regulators paid little notice to the effect on the motives of exchange leadership of the change from a trader-serving marketplace to a self-serving marketplace.

Exchanges' historical mutual ownership organization, the result of the gradual organization and reorganization of traders and other financial specialists, had originally pursued the goal of creating a common locus and facility for the trading of financial instruments or commodities. For most of the history of exchange trading, the function of an exchange was simply to provide a single location for traders to congregate.

Thereafter, exchanges formed systems for market governance and rule-making for their members. The exchanges of the past were a level of market self-governance, a buffer to potentially harsher governance by government regulation. The assumption by the SEC that profit-making exchanges would continue to govern the marketplace without self-interest was, in hindsight, naïve.

What the SEC was thinking.

However, there was awareness and concern at the government level about the market structure implications of for-profit exchange management from the beginning. In the old days of voice trading, transactions had exhibited a tendency to gravitate toward a single marketplace, raising the specter of monopoly behavior. Market regulators had no appetite for a return to the pre-1990 monopoly structure that had characterized the market for common shares, for example, at the New York Stock Exchange.

It was out of concern that the exchanges might become monopolies that the SEC passed a rule that seemed, ex ante, to be in the best interest of the market's risk manager customers. The SEC mandated that brokers place every order at the best available price across all exchanges. This rule guaranteed that any SEC-approved exchange would capture fee income from selling broker/dealers early access to exchange feeds since without these feeds, a broker/dealer could not comply with the "best available price" rule. Thus, these fees would create profit resulting from exchange existence, not exchange quality.

Moreover, the best-available-price rule is unenforceable, since exchanges have different locations; and customers, locations different from exchanges. In a speed-of-light world, one cannot separate time from location.

The SEC's version of the prices of stocks traded at the exchanges is collected by the SEC computer, then distributed to the rest of the world as a single data feed called the Securities Information Processor (the SIP). However, the individual data feeds upon which the SIP is based are not comparable because distances of exchange computers from that of the SEC vary and the age of a specific exchange data feed must vary directly with the distance of the exchange from the SEC feed. When combined by the SEC into a single feed, these disparate exchange feeds produce price data that is both stale and not representative of prices available to traders at any particular time.

In short, the NMS objective of giving a customer the best price from any exchange at the time of the customer's fill is not possible for a broker to accomplish. It is an objective that inevitably was replaced in practice by providing a customer with prices superior to the SIP price seen by the broker at the time of the trade. This achievable goal left ample room for broker-dealer profits. The arbitrage of the SIP prices against prices at which retail orders are filled seems to be the only HFT arbitrage that the exchange management firms cannot extract from HFTs by increasing colocation fees.

The nonsensical organization of exchange management firms.

The SEC's NMS has produced a three-firm oligopoly, which may be on its way to becoming a single firm monopoly. Stock exchange trading is the only industry where firms have subsidiaries that claim to compete with each other. If the SEC allows nature to take its course, the stock exchanges may increase in number until they use all SEC licenses, but a single exchange management firm will own all licenses. At some time before market forces drive stock market organization into the ridiculous position of many subsidiaries simultaneously offering a single product within one firm, the SEC will doubtless feel compelled to reverse its NMS system.

How much better would it be if an exchange, new or old, offered a new product instead? The stock trading community would then show that it is, indeed, capable of regulating itself.

What does the SEC attack on exchange profitability mean for investors?

The SEC's decision to address the innate conflict between the exchanges' self-regulatory status and their for-profit status leaves the exchange management firms with two choices.

  • The exchange management firms can drop their SRO status, each firm can combine its multiple exchanges, and the firms can compete in fact.
  • The exchange management firms can spin off their re-mutualized exchanges. The mutually owned exchanges can retain SRO status.

Neither decision will improve the value of the exchange management firms' shares. In my judgement, the firms will not make either decision unilaterally. This leaves the marketplace as a whole with two choices.

  • Market users introduce a new exchange that, through offering new products and services, provides real competition to the existing exchanges.
  • The SEC can deny the exchanges SRO status.

This article was written by

Kurt Dew profile picture
My primary interest is financial market structure. I write about market platforms, index instruments, and exchange management firms primarily. I was a member of the team that introduced index trading at the CME. Later, I pioneered the secondary market trading of OTC interest rate swaps.

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. I have no business relationship with any company whose stock is mentioned in this article.

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