The Money Tango: Market Power and the Modern Stock Exchange
This piece originally appeared in Business Insider on May 23, 2018 under the headline “Competition among exchanges has reached a new low, and it’s dangerous for the stock market.”
ICE, the parent company of NYSE, this week relaunched the old National Stock Exchange, after acquiring its license early last year. This follows last month’s news that ICE has agreed to acquire the Chicago Stock Exchange, after CHX failed to get regulatory approval for a plan to be acquired by a group of Chinese investors.
But media reports are missing what I think is the bigger story, which is the long-term effort by three multinational conglomerates to use control of U.S. stock exchange licenses to perpetuate their dominant position, as if those licenses were properties on a Monopoly board. With the CHX deal, they now own all but one.
The practice of buying and selling exchange licenses is relatively recent. Back when exchanges were still owned by their members, in addition to NYSE and the American Stock Exchange, there were a raft of regional exchanges spread across the country, some with roots in their communities going back 100 years or more. The others were always minor players compared to NYSE, but the competitive landscape changed as markets evolved and new electronic trading platforms, like Archipelago (or Arca), were given the right to compete. Some venues merged and became full-fledged exchanges. Nasdaq went international and obtained its own exchange license in 2006. NYSE gobbled up the Pacific Stock Exchange/Arca (which had merged in 2002). BATS emerged as an industry consortium and gained two new licenses in 2008, followed by Direct Edge, which received two licenses.
Compare the landscape today. There are 15 approved stock exchange licenses (13 that currently trade equities). Nasdaq’s holding company owns 4 (Nasdaq, the successors to the old Boston and Philadelphia regional exchanges, and ISE, an options market that retains an equities license). ICE has 5: NYSE, American, Arca, National (which was once the Cincinnati Stock Exchange), and now Chicago. Cboe, once solely an options market operator, owns another 5, counting its own equities license and the two BATS and two Direct Edge markets. IEX is now the only registered exchange independent of the three conglomerates.
What’s more important is that the three mega-companies all compete in the same way, meaning they use the same business model to hold on to their market share and squeeze as much money as possible from the industry in the form of the fees they charge for market data and the right to connect to each exchange they control. There are three steps to this tango: keep the controlled exchanges separate, rather than consolidate; use rebates to lure quotes and orders that brokers must access under the current regulatory scheme; and, finally, keep hiking the data and connectivity fees that the industry must pay to navigate 13 markets.
Step 1: Maintain the separation between the markets. Does NYSE actually compete with NYSE American or NYSE Arca or NYSE National? Will they now compete with NYSE CHX? Of course not. In theory, consolidation should make sense — all stocks today trade on every exchange, and if you can bring more buyers and sellers together in one place, you should be able to deliver better results. But you can deliver better profits to the exchange another way.
Which brings us to Step 2: The regulations require orders to be steered to exchanges whenever they set or match the best price, so if a market operator can use rebates to lure more quotes, every exchange it owns can claim some portion of the total market pie. As a result, every firm that trades actively for itself or its clients is required to connect to every exchange, directly or indirectly.
Leading to Step 3: Because of the excess “friction” caused by 13 exchanges, active brokers and trading firms have to pay (a lot) for market data and connectivity to each exchange. As former SEC Commissioner Dan Gallagher put it, “My take is that there have been some abusive practices — the fluctuation, the arbitrariness with which fees have been jacked up, and the monopolistic power that goes behind it — there is a problem.”
The root problem is this: Exchanges control the means by which their members must interact with them. Is there an example in the annals of business where companies, armed with this kind of market power, choose to exercise self-restraint?
The three steps are interconnected, but there is a limit to what the regulators can do to intervene. They don’t have a good way of forcing consolidation, and SEC resources are challenged, to say the least, by the task of reviewing hundreds of fee filings every year. The SEC is, however, threatening to interrupt step 2 of the dance with its recently proposed transaction fee pilot, which for the first time would require exchanges to trade a group of stocks without offering rebates. When you hear their howls of protest, and they are coming, about how even testing such an idea will lead to chaos and destruction, you may now have a better idea where that comes from. The stakes are high, and not just for exchanges, or brokers and traders. Investors pay the costs of rising exchange fees and sub-optimal executions. Public companies also lose out because the stability of the market for their shares is undermined by this arbitrary fragmentation and pinball-like movement of orders among all the captive markets.
Competition is a great strength of our economic system, and IEX has been proud to compete for business as a single market, without rebates, and without charging for access and data at extraordinary multiples of what it costs to provide it. We think that model can prevail if the market has the chance to choose it, but that may require setting new rules of competition and stepping on some exchange toes, mid-tango.
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