- As the importance of investment management firms (IMFs) and their generic index products grows, market structure will inevitably change.
- The evolving market structure will add a second transaction chain, focusing on the needs of IMFs and their customers.
- The losers will be the incumbent stock exchanges. The winner, an IMF or a futures exchange.
This article compares present market structure, a transaction chain dominated by four big exchange management firms [Intercontinental Exchange (ICE), Nasdaq Inc. (NDAQ), CBOE Global (CBOE), and CME Group (CME)], to a future market structure where exchanges no longer hold the spotlight. This new market structure will be dominated by IMFs like BlackRock Inc. (BLK), State Street Corp. (STT), and Vanguard Group.
As the importance of IMFs and their flagship products, index funds and ETFs, skyrockets, the present market structure saddles IMFs with costly exchanges providing expensive unnecessary services.
But with shifting importance comes opportunity. New trading platforms arise to meet IMFs’ less expensive needs. As the markets evolve the old transaction chain linking securities issuers through incumbent exchanges to individual issue traders is unchanged. The new second chain focuses on IMFs’ needs and opportunities.
Present market structure
Individual issue traders, at one end of the existing transaction chain, seek to participate in, to influence, and to benefit from the decisions of corporate issuers at the other end. A middleman exchange provides services fueled by minute-to-minute changes in market information. But the incumbent exchanges are expensive from the point of view of IMFs and their users. Only individual issue traders need this expensive information.
Products offered by IMFs are based on the principle of passive management. To wit: Efficient portfolios contain all positive market value instruments in proportion to market share. An important byproduct of this principle is that IMFs have minimal transaction costs and no need whatever for minute-to-minute market information.
The expensive services of the old exchanges are near-worthless to IMFs. They conduct two kinds of transactions. They revise their portfolios when new corporate shares enter an index or leave it. In addition, they access a liquid market for ETF shares. Thus, the change in market structure is not about what IMFs need. It is about an opportunity.
Different market structures
IMFs and their customers are best served by dramatically reducing the cost and importance of exchange services. Interestingly, the IMFs need two kinds of trading platforms – one to meet IMF portfolio management objectives, and one for IMF distribution to customers.
The graphic displays two transaction chains. The red chain serviced by incumbent exchanges meets the needs of corporate issuers on the sell side of the transaction chain, and individual issue traders on the buy-side. The green chain services IMFs and their customers. The red transaction chain is familiar. The green transaction chain servicing IMFs and their users is new.
As the stocks within a given index portfolio change, IMFs conduct a relatively complex transaction. They swap stocks exiting the index for stocks entering the index. Electronic brokers, notably Interactive Brokers (IBKR) execute these "basket" trades. Considering the order’s complexity, likely these platforms will remain a sell-side service – broker competition rules, each competitor with its own platform.
The distribution platform is where change may come. At the distribution link in the IMF chain, IMFs have two broad choices. To simply issue and retire ETFs in response to the difference between the market value of the ETF and that of its shares, or to control the entire process. The less ambitious alternative exists today. But the profits from controlling the entire process are more attractive.
Call the second alternative an IMF-driven exchange. It adds value to the marketplace. An IMF-driven exchange might offer different services from that of the existing exchanges by targeting markets for generic products like ETFs that do not require the high-cost services of incumbent exchanges.
Comparison with futures exchanges
What is a generic product? Consider the listings of futures markets. Historically, futures markets were barred from listing contracts based upon individual corporate issues. As a result, futures exchanges list any imaginable generic product and nothing else.
The futures exchanges’ ambitions have stopped short of listing spot markets for these same generic instruments. In missing the opportunity to list futures-related spot markets, the futures exchanges have paid two prices:
- First, they have made themselves vulnerable to the disruption of their existing markets when the related cash market outside the control of the futures exchange fails. This may be the fate of the CME’s Eurodollar futures contract. See here and here for discussions of this possibility.
- Second, they have missed the revenues that listing the related cash market would produce.
The missing link – generic spot markets – is the IMFs' bread-and-butter. The IMF might gain what futures exchanges have – revenues from the exchange trading of both cash and futures markets in generic issues. Alternatively, the futures markets might gain what the IMFs have – interest revenues from securities lending.
Thus, the innovating exchange, either tied to an IMF, to a futures exchange, or both has an opportunity. By combining exchange trading with investment fund management, the combined organization can identify exchange fees and securities loan interest charges that maximize profits across all services, new and old.
And there is a dividend to tying a spot and futures trading exchange to an exchange-issued generic instrument – added protection for market sustainability. Not only might the innovating exchange create greater income for the innovator at a lower cost to its customers, but the combination of futures and spot will be safer. The threatened death of Eurodollar futures could have been prevented, had CME listed a cash instrument that settled Eurodollar futures from the beginning.
In short, by integrating futures and spot trading with issuing and management of investment funds, all four activities can be pursued with a view to extracting the greatest revenue from the four while providing the services of these same activities at a far lower cost. A side benefit is that the risk exposure of each product line is far lower as well.
How an IMF exchange would work
Securities lending interest income is the key to the competitive advantage that an IMF-driven exchange would have in comparison to an incumbent exchange. An IMF with an exchange attached could determine the mix of exchange fees and interest that maximizes the profits of the whole operation.
The first flow chart displays the flow of funds during when-issued trading before settlement. The structure of when-issued trading is akin to Treasury when-issued trading and identical to futures trading. A central clearinghouse serves as the buyer to seller and seller to the buyer. The investment fund has no role in these transactions.
The second flow chart displays the flow of funds in a settlement. In a settlement, the buyer pays the investment fund, through the clearinghouse, taking ownership of the instrument issued by the investment fund. Seller plays no part in this transaction.
The third graphic displays seasoned issue trading. During seasoned issue trading, buyer's payments and receipts, if any, are to her broker, stopping short of the exchange clearinghouse. Seller pays margin to or receives a margin from the investment house through the exchange.
There is a more complete description of the workings of an IMF-focused exchange here.
Winners and losers
As trading and investment interest move from individual issue trading to generic products trading, the old high-cost model of exchange trading will shrink in importance, augmented by a lower-cost IMF exchange suited to the trading of generic products as they become a greater share of trading. The losers are the incumbent exchanges.
But which kind of institution will dominate the future? Will it be CME Group, with most of the necessary trading apparatus in place? Will it be BlackRock, with the necessary financial acumen and investment fund management expertise? Or will it be a dark horse?
This article was written by
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