In early January, a group of the largest equity trading, brokerage, and retail firms – including Morgan Stanley, UBS, Citadel Securities, Virtu, Charles Schwab, E-Trade, TD Ameritrade, Fidelity Brokerage, and Bank of America Merrill Lynch – announced that they were funding the development of a new stock exchange, called the Members Exchange, or MEMX, to compete with the existing US equity exchanges. TABB Group founder and research chairman Larry Tabb breaks down how these market players would benefit from another equities exchange, what strategies MEMX is likely to pursue, and the threat it presents to the incumbents.
In early January, a group of the largest equity trading, brokerage, and retail firms announced that they were funding the development of a new stock exchange, called the Members Exchange, or MEMX. Morgan Stanley, UBS, Citadel Securities, Virtu, Charles Schwab, E-Trade, TD Ameritrade, Fidelity Brokerage, and Bank of America Merrill Lynch have banded together to develop an exchange to compete with the existing US equity exchanges.
The question is: Why on earth do we need a 14th US equity exchange?
To understand why the brokers feel they need a new exchange, you need to understand a bit of history. Historically, there were two major equity exchanges: the 200-plus-year-old NYSE and the Nasdaq. These were member-owned exchanges that operated like utilities. After some regulatory challenges with the NYSE and Nasdaq, the SEC opened up the exchanges to competition, and a number of new equity matching platforms were developed. These new quasi-exchanges launched in the late 1990s/early 2000s and, while they looked and acted like exchanges, they were called ECNs and operated under a lower regulatory threshold. These platforms automated predominantly the Nasdaq market. In 2005 the SEC passed Regulation National Market System, or Reg NMS, which forced the NYSE to face competition as well.
By the mid-2000’s the traditional exchanges were also allowed to go public as they moved away from member-owned utilities. During the late 90’s and early 2000s, the traditional exchanges bought up the ECNs, and just as it appeared that the market would be reconsolidated under NYSE and Nasdaq, Dave Cummings, the CEO of Tradebot, along with another high-frequency firm, Getco (which became Knight and subsequently was acquired by Virtu), entered into the ECN space with the development of BATS. By 2006 BATS obtained funding by industry participants and it became a quasi-industry consortium.
When BATS entered the market, it provided competitive pressure to keep both Nasdaq and the NYSE in check. However, as BATS grew, an opportunity emerged for BATS to become a full-fledged exchange (2008), go public (2016), and, in 2017, get acquired by Cboe.
As BATS went public and subsequently was acquired by Cboe, its governance changed. Once BATS became public and was acquired by Cboe, instead of being managed as a lower-cost industry-owed entity, it needed to be run like a for-profit entity, similar to the NYSE and Nasdaq. During the 10-year span since BATS became an exchange, other exchanges were acquired by the NYSE and Nasdaq, until we reach today, when the 13 US equity exchanges are all – except for one, IEX – owned by NYSE (which was acquired by ICE in 2012), Nasdaq and Cboe.
As the major exchange groups consolidated many of the competitive exchanges, industry brokers/institutional investors began to feel that the exchanges were becoming less responsive to the dealers (and their clients) that sent them order flow. This created frictions between the dealers and the exchanges and culminated with the October 2017 SEC Market Data roundtable, where it appeared the dealers and larger investors were targeting the three major exchanges as being non-responsive, while the exchanges responded that the industry was being needlessly greedy and attacking their business model.
Et voilà, the announcement in early 2019 of the Member Exchange.
So What’s MEMX Thinking?
TABB believes MEMX’s initial strategy will include the following:
While BATS started out as an ECN (a lit ATS), the opportunity to become an ECN has become problematic, as ECNs are not entitled to SIP market data revenue, which could easily provide MEMX with $10 to $20 million a year, as IEX with less than 3% market share generates approximately $10 million in SIP revenues. In addition, given the competitive threat, the order routing facilities that used to be operated by some of the smaller exchanges are no longer in operation, meaning an ECN needs to rely on an exchange for universal access, and given the competitive threat, it is unlikely that an exchange owned by the large three providers would develop that infrastructure. So, for MEMX to share in SIP revenues and control its own routing, it needs to become a regulated exchange.
The fastest way to obtain exchange status is to deploy a “cookie cutter” exchange, modeled exactly like an existing exchange. Unlike IEX’s speedbump, which caused a two-year licensing delay, MEMX will most likely employ a standard maker-taker model, with virtually nothing odd or controversial. While the other exchanges may complain about the added complexity of a fourteenth exchange, MEMX’s exchange application will be completely dull and boring, raising no flags with regulators. That will speed up approval and remove any possible SEC delays.
Once approved, MEMX, operating off the BATS playbook, will most likely employ the ‘Crazy Eddie’ “our prices are insane” pricing strategy: MEMX will provide a larger rebate than its cost to take liquidity. This will achieve two goals: first, it will provide an incentive for market makers to provide liquidity; and second, that incentive will be passed back into more aggressive pricing. While most of the high-rebate exchanges have super tiers of 32 mils (cents/share), MEMX will need to provide a higher rebate than 32 mils or provide more clients with access to the 32-mil top tier. Interestingly, these high rebates and the conflicts that it creates, is exactly what the buy-side is railing about, forcing the SEC to implement the new Access Fee Pilot, which I will discuss later.
The aggressive rebate-supported pricing will enable MEMX to display better prices, which not only attract more market orders, the aggressively priced orders will push other exchanges to route flow to MEMEX via Reg NMS’s Order Protection Rule (OPR).
To fund this ‘Crazy Eddie’ pricing, MEMX has raised $70 million in funding, according to the Wall Street Journal. That is much more capital than the start-up needs. I would argue that much of this $70 million –maybe as much as half – will be used to fund this aggressive rebate scheme.
While it is important to have a high rebate, because it subsidizes aggressively priced liquidity and takes advantage of the OPR, MEMX also may implement an artificially low take fee, which would make it less expensive for investors to take the exchange’s aggressively priced liquidity. Since many of the exchange members either are retail and/or institutional brokers that take more liquidity than they provide, the lower take fee would reduce trading costs for these members.
Creating an exchange that raises capital only to pay it back to its members is a nice thing; however, becoming an exchange provides the partners (Morgan Stanley, UBS, Citadel Securities, Virtu, Charles Schwab, E-Trade, TD Ameritrade, Fidelity Brokerage, and Bank of America Merrill Lynch) a say in exchange governance as they become part of the SRO governance structure. Becoming an exchange provides these firms a say in how the exchanges operate as a whole. This was lost when BATS went public and was subsequently sold to Cboe. When MEMX becomes an exchange, it will get one seat at the table; however, if it creates other exchange models and obtains other exchange medallions, which is likely over time, it will gain increasing voter rights in SRO governance.
In the short term, MEMX will provide its members with three major advantages: more aggressive transactional pricing, a say in US equity markets governance, and a share of market data SIP revenues.
But is it a threat to traditional exchanges?
Initially, this will mean very little to the existing exchanges. While competition is challenging, until MEMX can gain more than 5% market share, and more likely closer to 10%, there will be little incentive for the existing exchanges to concede prices or change their competitive stance. In fact, in the short term, creating a competitive exchange may increase the costs of the major brokers.