The Strange Economics of Exchange Management

The SEC’s Regulation National Market System, or Reg NMS, has created unintended market incentives that drive exchanges to seek consolidation, rather than introduce competition among the exchanges, as intended. As a result, any significant progress in improving the efficiency of financial markets will come from markets outside the SEC’s NMS goat rodeo.

The important decisions that will determine the future of financial markets in the new decade will help solve two market problems: first, bringing greater efficiency to the government-created market oligopoly of publicly held exchanges that serve the entire market; and second, updating the retrograde derivatives markets. However, any significant progress in improving the efficiency of financial markets will come from markets outside the SEC’s National Market System (NMS) goat rodeo.

The distinction between the two kinds of ETFs trading generic instruments – stock index ETFs, on one hand; and financial futures, on the other – is a historical artifact that ultimately will fade away.

The markets are evolving toward a two trading-space system. The first: exchanges trading SEC-regulated publicly held corporate equity and debt; the second: exchanges trading more generic non-SEC-regulated markets.

The SEC-regulated space

Privately held SEC-approved exchange management firms (EMFs) such as IEX and MEMX focus narrowly on a single market subsector. As a result, they are fated to become bit players among the established publicly held stock market managers with a broader market-appropriate focus. If, however, they were to go public, the two would be snapped up by the big three EMFs. In short, privately held narrowly focused EMFs may be doomed to marginality.

The government protected oligopoly theory-driven mainstream big three EMFs are Intercontinental Exchange, Inc. (ICE); Nasdaq Inc. (NDAQ); and CBOE Global Markets Inc., (CBOE).

This article traces some important implications of the tense struggle between the SEC and the big three EMFs, finding that the big three practice of cloning new exchanges to collect extra fees contains the seeds of these EMFs’ own destruction. The big three will merge unless they find a safer, less lucrative political alternative to the economic solution.

[Related: “US Equities Exchanges: Warring States, Finding New Equilibrium”]

Alternatively, a blockbuster exchange newcomer outside the SEC-regulated space might encourage the merger of the big three under new competitive pressure. In the presence of new competition outside the SEC’s jurisdiction, the SEC might not object to a merger of the big three EMFs.

With no serious external competition for a merger-created single EMF, the SEC will be forced by antitrust considerations to require a single EMF to divest its lone exchange. But with a life-threatening external competitor, the lone exchange might be acceptable to the SEC. Ironically, this outside competition, by providing a rationale for a for-profit single SEC-regulated exchange, also maximizes the value of the SEC-regulated exchange. Strangely, the last for-profit SEC-regulated exchange derives its raison d’etre from the competition of a single external exchange.

The generic instrument space

The article concludes with a combined forecast of the fate of the generic markets outside SEC jurisdiction, and the corporation-originated instruments destined to remain SEC-regulated; arguing that the generic cash markets will ultimately become one with their associated futures markets. Index ETFs, for example, will migrate into the Commodity Futures Trading Commission’s turf. The result: a stable outcome consistent with the competitive economic model.

The exchange mavericks

IEX. True to its ethos, IEX is planning a new kind of limit order, the discretionary limit order (D-limit), designed to further frustrate IEX’s old antagonists, high-frequency traders (HFT). The intended beneficiaries of this new order type are buy-side dark order traders. IEX is built to serve the buy side. IEX will stay that way because it is privately held by buy-side firms.

IEX is the first of a nascent collection of privately held market mavericks, swimming against the current created by the poorly framed SEC Reg NMS, the regulation that turned the big three into market parasites. IEX’s privately held status is the key to its survival. As demonstrated by older exchanges like BATS – once publicly traded and independent – any EMF, whatever its original intention, is driven by market forces into the clone-creating hands that value it most. An EMF maximizes the value of a newly acquired exchange by converting it into one among many clones of the big EMFs’ parent exchange, or in BATS’ case, by becoming the parent exchange itself.

The maximum value of any newly SEC-anointed stock exchange, thanks to the NMS, is as a market parasite, feeding off the exchange fees that broker-dealers pay. These broker-dealers are driven by the pressure of competition for customer business to pay exchange fees they think are excessive.

MEMX. A second proposed new exchange, Members Exchange (MEMX), is also designed to thrive outside the government-created oligopoly but guided by the interests of the HFT community and its newfound allies, retail brokers. MEMX, like IEX, is built to serve a narrow market subsector constituency.

These two maverick firms frustrate the market forces that would otherwise drive them to become clones of the main exchanges, avoiding the fate of BATS – an exchange swallowed up by CBOE. Once captured by CBOE, BATS dropped its original intent to distinguish itself from the other big exchanges by reducing exchange fees.

However, by limiting themselves to a narrow sector of the trading marketplace, the maverick exchanges marginalize themselves. The brokers’ need to search for the best price market-wide will inevitably attract some of the exchange mavericks’ targeted subsector customer business to the big three, further reducing the mavericks’ liquidity.

The big publicly held stock exchanges, creatures of regulation

Nonetheless, the mavericks may have the last laugh when the big three implode, driven to merge by the economics of the NMS. The big three tend to follow the dictates of the government-protected oligopoly model because they are publicly held, and SEC regulated. And the NMS makes owning an SEC-designated exchange a path to easy money.

What’s wrong with the stock markets?

The weird twist to this industry is that the big three EMFs maximize oligopoly rents by acquiring many smaller exchanges, using them to clone the dominant parent exchange within the acquiring EMF. By buying up superfluous exchanges, an EMF does not increase trading volume or reduce trading costs. Multiple clone exchanges increase market-wide exchange fees for no purpose other than the EMF’s own enrichment. The exchange clones create a cost to other market participants with no offsetting benefit.

Using these clone exchanges, the EMFs create multiple internal exchange competitors within the same firm – economic nonsense created by the influence of Reg NMS. The SEC’s objective when it introduced Reg NMS was to create competition among the exchanges. But NMS, with its requirement that each trade is executed at the best available price, has forced broker-dealers to pay every exchange for a costly look at its best price before every transaction, no matter the cost.

The catch that the SEC didn’t consider: The implication of the regulation is that every major broker-dealer must pay the toll for all the paths, all the time. That is the NMS defect. It produces EMFs that own multiple redundant exchanges used to multiply the fees a single EMF can extract from broker-dealers. If there is any real competition between EMFs, it’s a contest to see which EMF can extract the most fee income from broker-dealers per transaction.

I have argued elsewhere that the primary source of the parasitic behavior of the big three stock EMFs is this lethal combination of the publicly held profit motive and unintended government-induced motive to add exchange clones.

The endgame inside the NMS

The barrier to the addition of more clone exchanges, increasing EMF participation in SEC-created oligopoly profit, is the agency’s reluctance to permit more parasitic clones.

The long-run implication of the government-protected oligopoly model is the reality that EMF profitability is increased through the interaction of two exchange decisions.

  • First, clone-creating EMFs are more profitable merged than separate if each of the merged exchange subsidiaries remains open for business – a force that encourages industry consolidation.
  • Second, adding a clone exchange within an EMF is always profitable – a force that drives each publicly held EMF to add as many clone exchanges as possible.

The bizarre ultimate economic effect of these two forces, in the long run, is a single for-profit super-EMF. However, this value-maximizing outcome has regulatory consequences that might lead the exchanges to negotiate a less lucrative truce before the acquisition war reaches its natural end.

The path to the long run in stock markets

Consolidation: Market forces drive the EMFs to merge, ultimately reaching a ridiculous endgame where one EMF owns many exchanges. Interestingly, the SEC is resisting this embarrassing outcome, delaying the exchange designation process to stem the competitive tide.

The SEC wishes to create the maximum number of EMFs, each holding a minimal number of exchanges, exactly opposite to the market incentives the SEC created with its Reg NMS. Hence the SEC’s new interest in creating privately held EMFs that will not become clones.

The cloning EMFs and the SEC are locked in a continuous struggle. The SEC permitting new independent exchanges; the EMFs, acquiring them. The political endgame begins when competitive forces produce a single super-EMF, owning many exchanges, the economic outcome.

After consolidation: But ironically, if the endgame produces one EMF owning many exchanges, the SEC will have no trouble convincing legislators that n-1 of the n exchanges are market burdens and should be closed. Yet this monopoly, a single EMF owning one exchange, is also unacceptable to the SEC.

The lone EMF will be forced by antitrust considerations to divest its exchange operations. But this monopoly outcome will spell the doom of for-profit exchanges altogether. The resulting single exchange will become a mutualized membership organization with a heavy SEC hand in governance, returning us to the pre-2006 status quo ante – a mutually held membership-managed firm.

In short, if the EMFs remain faithful to their value-maximization objective, they will merge themselves out of the exchange management business. Not a good result from the EMS’s point of view. Thus, we may remain locked by political circumstances into the existing three-exchange environment, with neither the SEC nor the EMFs satisfied.

[Related: “A Buy-Side Perspective of Equities Market Structure: Winter Is Coming for the Exchanges”]

Unless a new successful blockbuster exchange, outside the NMS, enters the fray. Perhaps then neither the SEC nor the EMFs would object to a merger of the big three.

Does the SEC support mavericks?

IEX, the first exchange to successfully press the SEC to open the once closed gate to exchange designation, overcame initial SEC resistance to its exchange designation through its focus on an ethical red herring. The lame story that got IEX the SEC’s green light was the argument that HFT activities were somehow evil; institutional buy-side traders, good. Michael Lewis’s “Flash Boys” – a book that accused the existing stock markets of being rigged in favor of HFTs – spun this yarn.

IEX’s management ignored the economics of for-profit exchange operation, maximum profit; to pursue an alternative motive, serving the needs of its buy-side masters. IEX, consistent with its decision to maximize its value to a market subgroup, the buy side, lives on because it is privately held by buy-side firms and is unwilling to accept new cash from other investors. This way it avoids the market forces that would otherwise drive it into the arms of the big three EMFs. It is not willing to be sold to the highest bidder.

MEMX, on the other hand, has a similar desire to be different but is more forthright. It didn’t use IEX’s sensational misdirection. MEMX chose a name consistent with its intentions: Member’s Exchange.

MEMX appears to many observers to be designed to pursue a single generic transaction: retail order flow, HFT-acquired, and exchange-reacquired. To that end, the exchange is owned by HFT firms such as Citadel Securities and Virtu Financial Inc. (VIRT); and by retail brokers such as Charles Schwab Corporation (SCHW), E*Trade Financial Corp. (ETFC), and Fidelity National Financial Inc. (FNF).

[Related: “MEMX & Equity Exchange Competition: Déjà vu All Over Again”]

The SEC realizes that private ownership prevents the two maverick exchanges from becoming clones. The mavericks thus further SEC objectives. Nonetheless, these privately held exchanges will never bail the SEC out of its NMS mess. They are a sideshow outside the three-ring ETF circus.

To return the exchange community to efficient, profit-maximizing operations, a blockbuster exchange – with operations that reduce the real operating cost of trading, not just trading fees – may emerge. This exchange would simultaneously bring the generic markets for futures and indexes up to date and provide a competitive threat, giving the SEC a motive to permit the sought-after merger of the big three. The blockbuster exchange would optimize its value outside SEC jurisdiction. The remaining exchange inside SEC jurisdiction would no longer be hampered by Reg NMS and would maximize the value of the remaining exchange within SEC jurisdiction.

What works in generic markets outside the NMS?

To ask what this blockbuster firm would look like, look at the major financial market that is not SEC-regulated. The existing model that works outside the NMS system is CME Group (CME). This futures EMF has avoided capture by the NMS by never listing SEC-regulated securities. As a result, the CME has become the model of an exchange in a purely competitive environment. A single firm, each listed instrument trading on a single exchange.

But CME has a major weakness that opens the generic financial markets to invasion by a new blockbuster exchange.

What properties lead to CME success?

There are three properties that make futures trading more efficient than stock market trading:

  • Regulatory permission to trade an entire market with prices revalued daily at a single exchange-determined closing price.
  • An exchange that serves as the counterparty to buyer or seller in every transaction.
  • Trader ability to take a beneficial interest in the traded instrument without ownership. No Depositary Trust Clearing Corporation costs.

The question is: How can the properties of futures that permit the CME to operate outside the NMS be generalized to include more instruments, with a broader appeal? In other words: Within the CFTC-regulated trading space, where is there room for another blockbuster exchange?

The firm that answers that question may capture the futures exchanges’ markets and several lucrative cash markets (index ETFs, foreign exchange, and generic fixed income instruments, for example) that are sufficiently broad to elude the SEC’s mandate to regulate the securities of individual companies.

Would replacing derivatives enhance market stability?

Derivatives were introduced originally to help reduce existing market instability. In the decades after the collapse of the Bretton Woods Agreement, it became clear that price risk transfer in financial markets was inadequate to prevent a series of financial crises, notably the Savings and Loan Crisis during the decade following 1985. Financial futures were the first derivatives to tackle price risk management problems in financial markets. Financial futures were followed by over-the-counter derivatives, swaps, that could penetrate a market where futures had failed – the market for the hedging transactions of customer firms that defer recognition of changes in asset values.

Derivatives filled a vital risk management need when they were introduced. However, over time derivatives have proven to be kludges. Their anachronistic market structure leaves room for a new exchange to seize their markets; unless both the CME and the OTC derivatives dealers upgrade the existing derivatives market structure.

Control of futures’ associated cash markets. There is no way to trade a spot market with futures-like credit risk protection and market valuation properties today. The approval by the CFTC of ICE Bakkt overnight futures proves, however, that the CFTC is openminded about the distinction between futures markets and spot markets. The CFTC has shown it is willing to call a spot market a futures market if asked.

The greater weakness of OTC derivatives. OTC derivatives such as interest rate swaps are more inefficient than financial futures. The clearing of OTC instruments does not put the exchange in a universal counterparty role and does not mark swap valuations to market within dealer portfolios at a single market-determined value, properties that are essential ingredients to the success of futures.

OTC derivatives were created to solve the accounting problem futures create because futures must be marked-to-market to protect the capital-lite futures exchanges from credit risk. Hedging firms that defer their cash-based income find this mark-to-market valuation property of futures inconsistent with their other reporting requirements. Hence the need for OTC derivatives, which delay payments to match up to hedgers’ cash market payments, solving the accounting problem futures created.

It seems to occur to almost no one, other than derivatives industry insiders, that swaps, by permitting deferred valuation and payment, reverse the efficiencies futures introduced to financial markets. Swaps have the credit risk and market valuation problems futures are designed to eliminate.

OTC swaps solve a superficial accounting problem by recreating the real hazards futures eliminated.

Market insiders have a very clear understanding of this fact. Among other negative effects of OTC derivatives, swaps have been a major factor in the mergers of dealer banks within the banking system during the financial crisis – reducing the number of important OTC derivatives dealers to only four large banks.

The big firms that dominate the OTC derivatives industry have skirted the impact of OTC derivatives’ credit risk on themselves through a drastic measure – successfully lobbying Congress to change the bankruptcy code. A swap clearing counterparty to a bankrupt entity may seize collateral immediately, without the permission of the bankruptcy court. Congressional bankruptcy legislation put swaps dealers and clearing counterparties at the front of the line in bankruptcy before the courts can rule on asset distribution.

Why derivatives trading is in transition

There are two strong forces driving exchange and OTC derivatives market change: the vulnerability of futures and OTC swaps markets to the failure of related cash markets they don’t control, and the systemic risks created by OTC derivatives.

The vulnerability of derivatives to related spot market failure. Futures and OTC swaps risk becoming collateral damage in the death of their related cash markets. Futures and OTC swaps markets are vulnerable because they cede control of the underlying cash markets that determine futures prices to others.

This vulnerability is already life-threatening for the CME’s Eurodollar futures complex and to the major LIBOR-based swap dealers. LIBOR is dying because the banks that determine cash Eurodollar market prices have deserted the cash London deposit market that ultimately determines Eurodollar futures prices. London has lost interest in the lightly traded London dollar deposit market where Eurodollar futures’ and OTC swaps’ values are determined. LIBOR’s death leaves the CME and the interest rate swaps dealers high and dry. This dependence on cash markets managed by others may be the undoing of the derivatives markets.

Futures are a kludge because exchange management has not unified futures trading with the cash markets that spawn them, leaving the futures exchanges to spin precariously, like tops, on an ephemeral, risky cash market base.

The greater vulnerability of OTC swaps. OTC swaps are particularly vulnerable because they create real systemic risks that can be eliminated by introducing a safer instrument. Creating a cash instrument that has deferral accounting-friendly characteristics to one counterparty, but mark-to-market characteristics for the exchange itself, would put OTC swaps’ systemic risk protection on par with futures.

A more stable reduction in market turmoil

There is a growing opportunity for a new blockbuster exchange to seize the volume going to generic futures and OTC instruments by a single exchange with spot trading capability. But to be successful, this spot market must be at least as efficient as the existing futures markets, reducing trading costs to a minimum, thereby attracting volume.

If this new spot/futures market provides both mark-to-market instruments and instruments with the deferred payment capabilities that gave birth to OTC derivatives like interest rate swaps, it can capture the entire derivatives market along with the associated deliverable cash markets.

By merging futures and swaps markets with their underlying cash markets, this new exchange could simultaneously reduce transaction costs and systemic risk. It would then be a suitable complement to the single SEC and broker-dealer managed stock exchange that the NMS may ultimately create.

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