The financial markets need an agenda. The recent focus of financial market commentary has been mostly negative – excessive exchange fees, Balkanization, and fragmentation. However, fulfillment of the promise of electronic trading asks for something more than lower fees.
A consensus agenda might emerge from public discussion of proactive changes to the financial marketplace that realize the full potential of electronic trading. What realistic objectives could entrepreneurs set? What path through the regulatory maze offers the least resistance?
Why IEX and MEMX are not helpful.
MEMEX’ (the proposed new stock exchange) press release told us more about what MEMEX isn’t than what it is. MEMX will reduce fees for exchange services, keep orders simple, and generally avoid gimmicks that favor one component (buy-side, sell-side, high frequency traders, institutions, retail). No IEX-like gimmicks that favor the buy-side (the speed bump, the discretionary peg, maybe no dark orders). IEX and MEMX are discussed here and here.
The primary focus of MEMX’ press release was on who it is, not what it is. The name, Members Exchange, says it all. The name gives the lie to one stated objective, to serve the interest of the member’s customers. MEMEX founding members include Morgan Stanley (MS), Fidelity Investments, Citadel Securities, Virtu Financial (VIRT) Bank of America (BAC), Merrill Lynch, UBS (UBS), Charles Schwab (SCHW), E-Trade (ETFC), and TD Ameritrade Holdings (AMTD). Every significant component of the trading community except the incumbent exchanges is represented, although the buy-side representation seems a little thin.
MEMX membership, as the press release betrays, is too diverse – this diversity militates against anything specific or different, limiting the potential for innovation. This new exchange intends to challenge the excessive fees charged by incumbent exchanges, and to slap aside IEX’ focus on the buy-side only. But the unanimity of support for MEMX by the trading community tells us something. The market is coming hard after the incumbent exchanges. Furthermore, the market has lost patience with the SEC. It doubts SEC capacity for exchange reform. Individual SEC commissioners have exchange reform on their minds, but as with all government agencies, interest group-driven political influences make the SEC slow.
MEMX, because of its absence of identified human leadership and the diverse nature of its putative corporate owners, might not proactively address barriers to progress facing financial markets. This lack of a positive agenda makes MEMX part of the problem in the same way that IEX is part of the problem. Both exchanges seem designed to address symptoms (high fees and a sell-side bias) of the basic sickness of financial markets: the wrong-headed, piecemeal, poorly considered, attempt by regulators globally to guide the transition of financial markets from OTC (phone-based) and floor trading to electronic trading.
Thus, these two exchanges, like NYSE, Nasdaq, and CBOE, will fall by the wayside as innovators ultimately pick their way through the regulatory mire to realize the benefits promised by electronic trading.
The barriers to marketplace efficiency.
Marketplace barriers can be identified borrowing from the classics of economic theory. Barriers to liquidity, credit risk management, diversification, and price discovery. The model of marketplace function that underlies economic theory is one of a single, costless, transparent market that generates a single daily settlement price for every traded good or service. What prevents this outcome? Three barriers to change:
Exchange for-profit corporate form
The direct way to achieve costless trading and price discovery would be through a single marketplace with costless transactions, eliminating the wasteful Depository Trust and Clearing Corporation (OTC:DTCC).
However, this single marketplace evokes memory of the past, when NYSE was a single marketplace. As with the typical monopoly of the time (the phone company, Standard Oil, JP Morgan) barriers to entry such as high startup costs once put NYSE in a position to extract rents, resulting in low quality, high cost, service. However, thinking about a single source for financial marketplace services should not be short-circuited by bad memories of the past. Cost of entry for new exchanges has become negligible compared to the reward – capture of the entire financial marketplace. A monopoly today would remain vulnerable to new entrants.
An entrant might further reduce its entry costs if it were not-for-profit. SEC commissioner Richards, joins the growing movement in this direction. MEMX might still choose this option. If MEMX is for profit, this failure to distinguish itself from historic failed attempts at reform, such as BATS, threatens MEMX with a similar fate – acquisition by one of the legacy exchange management firms bent on capturing even more fees.
Out of date securities market practices
Futures market practices are more efficient, less risky, and cheaper than securities market practices. The key differences between the high risk and cost of securities market practices and those of futures markets is the avoidance by futures markets of ownership and transfer costs, on one hand; and the assumption by futures exchanges of the responsibility for management of credit risk, on the other.
If an exchange were to create financial instruments itself, it could adopt futures market practices, since these securities would not be corporate liabilities, but liabilities of an exchange or, more likely, creations of its appointed custodian.
If a securities exchange were to assume custody responsibility as well as the responsibility for transfer of ownership, need for the DTCC could be eliminated. Transfer of ownership becomes identical to payment, eliminating separate clearing altogether. Further, exchange custody opens a new exchange function, origination of financial instruments, designed by the exchange.
Focus on security issuer needs; not risk managers’ needs
One of the most significant adverse consequences of incumbent exchange preoccupation with issuers’ needs at the expense of the needs of traders in the financial instrument exchange marketplaces is the failure to capture major trading interest in the two largest financial instrument markets, foreign exchange and debt. CME Group (CME), by acquiring NEX, shows its awareness of the potential of these two markets.
XTX Markets’ recent success in competing for electronic trades suggests foreign exchange is ripe for exchange entry. Large banks dominate the sell side of the foreign exchange market since these instruments are, at present, bank deposits. Forex is not negotiable. Both non-bank dealers and exchanges are at a competitive disadvantage to the banks, since they must go to banks, hat in hand, for access to the product. This is a major source of dealer bank profit. However, this market is ripe for taking, since any global bank can sell the original foreign currency deposit. It’s the capital cost of Forex dealing that creates the big banks’ oligopoly position in foreign exchange. An exchange that holds Forex collateral could easily subvert this advantage.
Debt is the most interesting opportunity. Consider the two risks that debt creates, credit risk and interest rate risk. The credit risk debt creates is closely analogous to the price risk that equity creates. As such, it is diversifiable. The theory of capital asset pricing suggests that like equity price risk, the credit-risk-minimizing strategy is to diversify across the entire debt marketplace. However, the low liquidity of debt in comparison to equity makes this strategy – already pursued by bond index funds and ETFs – more expensive to implement than for stock index ETFs.
Debt liquidity is low due to the subordinate position of debt holders in corporate decision-making. Debt holders are not protected from issuer management decisions that favor equity holders. To protect themselves, debt holders require extensive contractual protection in debt agreements. Among other things, debt holders expect their new debt issue to be limited to the amount of the current issue, requiring the issuer to create an entirely new, subordinated, issue the next time the issuer enters the market. Thus, a firm with one primary traded corporate share often originates many debt issues.
An exchange that holds managed collateral funds could provide useful debt with simple contract terms and supply enough of any issue sufficient to meet investor demand. The exchange could diversify assets backing its self-originated debt diversified across issuers.
The simplicity of exchange originated debt contract terms, and the assurance that the exchange would alter the terms of debt contracts only if it suited the interest of interest rate risk managers would substantially improve the usefulness of exchange-originated debt in management of interest rate risk. The exchange could offer debt instruments at maturities that satisfy risk manager demand, using other maturities issuers have chosen to offer. For a more detailed description, see my blog post.
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.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.