Members Exchange (MEMX) claims that through the benefits market participants will receive from MEMX’s SEC approval, the quality of electronic financial markets will improve. But as in any competitive environment, the effect of SEC approval of MEMX depends on whether the new exchange only mimics existing exchanges at the promised lower costs, or if MEMX truly innovates.
If MEMX plays its cards right, it could take the entire market, stocks, bonds, even derivatives, driving the other exchange management firms [CME Group (CME), Intercontinental Exchange (ICE), Nasdaq Inc. (NDAQ) and CBOE Global Markets (CBOE)], to the sidelines.
The MEMX news release asserts:
“MEMX's mission is to increase competition, improve operational transparency, further reduce fixed costs, and simplify the execution of equity trading in the U.S. In addition, MEMX will represent the interests of its founders' collective client base, comprised of retail and institutional investors on U.S. market structure issues. MEMX will seek to offer a simple trading model with basic order types, the latest technology, and a simple, low-cost fee structure.”
It is my belief, explained here and here, that the natural state of the transactions business is that of a single exchange. This exchange would issue a variety of user/risk manager-oriented instruments created by users themselves, with an exchange-designed chain from these user-driven instruments to the existing conventional issuer-driven instruments.
Single exchange domination was more or less the state of affairs circa 1980 when The Chicago Mercantile Exchange and financial futures generally took off. At that point, the New York Stock Exchange dominated the business of equities trading, and commentary from sources such as Business Week suggested that NYSE domination of futures was a foregone conclusion as well.
However, the technology of futures trading proved sufficient to the NYSE struggle with the result that two of the four dominant exchange management firms today are Chicago-based and futures exchange-created [CME and CBOE].
How can MEMX take over the trading world?
A legion of market observers, including myself, here and elsewhere, have argued that a policy mistake made by the SEC in guiding financial markets through the transition from floor trading to computerized trading stands out. This mistake turned the incumbent exchanges into market parasites. To wit:
Permitting the exchanges to operate for a profit, while requiring that broker-dealers execute customer orders at the best prices offered at the same time by any exchange, [SEC rule 611, the order protection rule] puts the exchanges in a position to extract oligopoly rents from their customers for exchange-provided data. Since every competitive institution must collocate at every exchange to know the best prices, all twelve exchanges will be paid their collocation fee by every broker-dealer of substance, no matter how much it costs.
Another legion of observers, for example, SEC Commissioner Jackson here, have argued that the exchanges have not been shy about snatching away the profits from trade execution once reaped by the broker-dealers and their customers in this new electronic trading world. However, the broker-dealers and large investors say they have had enough, and they are not going to take it anymore.
MEMX then is the intended response of market participants to this abuse by exchange management firms [MEMX is led by Morgan Stanley (MS), Fidelity National Financial Inc. (FNF), Citadel Securities, Bank of America (BAC), and Virtu Financial (VIRT), among others].
In response to this MEMX announcement on January 9, the shares of the primary exchange management firms [Intercontinental Exchange, CME Group, Nasdaq, and CBOE Global Markets all traded off on the day.
The market opinion of MEMX.
The initial opinions of onlookers have been surprisingly negative. See for example Kevin Dugan, Upstart MEMX exchange faces uphill battle against NYSE and Nasdaq.
Puzzling since a new exchange may be the only possible remedy for old exchange abuses. After all, the exchanges that do the abusing are not going to give up their ill-gotten gains unilaterally. That would be inconsistent with their obligation to their own stockholders.
There are only two ways to reduce the existing exchanges’ abuse of the market:
- Change the SEC rules that created the exchanges’ ability to extract rent from their captive users.
- Add an exchange that competes for customers outside the National Market System, thus reducing these excessive fees until the other exchanges are forced to give up and follow suit.
On the other hand, one exchange, Investors Exchange (IEX), which attempted to provide an alternative to the twelve existing parasites, has failed to provide a remedy for the ills of the marketplace. It is argued, by many including me here, that due to flaws in IEX’s business model, IEX does not provide a true test of the ability of competition to drive down the other exchanges’ usurious fees.
What could be wrong with MEMX?
It is much too soon to say anything is wrong with MEMX, in my humble opinion. Those who complain are saying:
- What? These MEMX sponsor people? Large banks and high-frequency trading firms (HFTs)? They have no clue. They have tried the same thing at least twice before with no success. For an example, see this by Stephen Gandal. Alternatively, this by Keven Dugan.
- How will MEMX reduce costs? If a broker-dealer routes orders to the best price on any exchange, the broker-dealers still need colocation at the other exchanges. Thus, collocation costs will remain unchanged, at best. The fact that MEMX collocation fees are lower (or nil) simply means that HFTs will race more trades and pull more orders at MEMX than at other exchanges. This will reduce the quality of MEMX prices and reduce its volume as well. In other words, MEMX will encourage transactions elsewhere – not a good thing for an exchange to do.
- All this is very plain vanilla, some say. Most critics argue that the MEMX initiative is an instant replay of BATS. BATS was an HFT-sponsored startup exchange that sought to change the market environment in the HFTs’ favor. At first successful, once acquired by the more profit-sensitive CBOE Global Markets, its behavior became indistinguishable from the other parasite exchanges.
Nasdaq in its response to the MEMX press release remarked, “With dozens of equity trading venues already in operation in the US, we are keen to learn more about the value proposition of a new exchange.” Nasdaq apparently thinks MEMX will not walk the walk.
These arguments, however, are not reasons for the SEC to turn down MEMX. If the sponsoring institutions simply lose money because MEMX fails, this is among the accepted results of the competition in a capitalist economy.
What could be right about MEMX?
That is a more interesting question. The answer, unfortunately yet reasonably, does not appear in MEMX’s press release, which limits itself to the promises quoted above.
What might the promises of MEMX in its press release mean, exactly?
- Improved operational transparency might mean an end to “dark” orders. An order book that is available to all traders, or at least all collocated traders. That would appeal to some customers but not others.
- The press release is not clear about how MEMX’ founders will “represent the interests of its founders' collective client base.” It will be helpful if MEMX is not for profit. MEMX would then represent a return to exchange behavior consistent with the self-regulatory mandate that the SEC intends. That would make the claim that “MEMX will represent the interests of its customers” more credible than the same claim when made by other exchanges that must put the interest of their own stockholders first.
- MEMX’s simple trading model. MEMX evidently intends to eliminate the intricate orders introduced by the other exchanges, purportedly for nefarious purposes, such as revealing the existence of hidden orders, something the other exchanges would be loath to imitate. That would be a positive sign that the HFTs driving the formation of MEMX intend to mend their ways.
- The mission statement indirectly criticizes IEX, another new exchange that seeks to woo the buy-side, by emphasizing simplicity. No “speed bumps” or “discretionary pegs” at MEMX, apparently. That would be a positive. IEX gimmicks are an Achilles’ heel. The IEX speed bump and the other IEX innovations all benefit marketplace users in a world where the other exchanges are supporting HFT arbitrage through collocation. If either the SEC’s National Market System were abolished or its effect on exchange fees eliminated, the speed bump, etc. would become an impediment to using IEX.
The bottom line is that to dominate, MEMX must do several difficult things:
- MEMX must create a means of using MEMX without dependence on collocation at the other exchanges. To do so, MEMX must render SEC rule 611 irrelevant for trades at MEMX. However, that requires an end run around the stock market. My belief is that the road to domination of markets generally is through the bond market. The CME, with its acquisition of NEX, an electronic platform for trading fixed income and foreign exchange, has taken that route.
- MEMX cannot be for profit. The SEC’s patience with new for-profit exchanges is at an end. Whatever the original intentions of a for-profit exchange, ultimately, these exchanges are bought by the highest bidder. This bidder includes profits from SEC rule 611 abuse in its calculations. If MEMX were not for profit, this would be a MEMX advantage in competition with CME Group.
- MEMX must innovate. The NYSE has repeatedly demonstrated that its response to a marginally profitable innovator is to acquire it. MEMX’s innovations must put distance between its market value and the resources available to NYSE for acquisition – as CME Group did in 2000.
- MEMX must beat CME to the punch. CME Group apparently does not intend to remain a one-dimensional futures exchange. CME looks like the exchange to beat.
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.