The failure of the US stock exchange model


Yesterday, we wrote an extensive piece questioning whether or not the NYSE/Deutsche Bourse merger was a good deal for America.  Joe also went on CNBC ( to voice our concerns and point out a few facts that many analysts seemed to have overlooked.  Namely, that the NYSE Mahwah data facility is considered “critical infrastructure” by the Department of Homeland Security and also that if the merger goes through, the new entity will also be the owner of 31% of the Direct Edge Stock Exchange. 

Our concerns so far have fallen on deaf ears and it appears that this merger already has a rubber stamp on it.  Yesterday, NYC Mayor Bloomberg came out and said the deal was good for New York.  Former SEC Chairman Levitt (and now advisor to Goldman Sachs and GETCO) also said this was a good deal and must be done.  And even more telling was the lack of voices coming out against the deal.  We didn’t hear a word from Sen. Chuck Schumer.  So it looks like the fix is in and this deal is going to happen. 

One reason why we questioned the deal initially was because over the past few years we have seen what stock exchanges will do to increase their bottom line.  The exchange business is a failed business model that got that way because of unintended consequences of regulations like Reg NMS.  But since the exchanges are all for-profit companies (two being public), they will often chase the same large customers and offer them many perks to get their business.  One example of this is the enhanced data feeds that the exchanges supply to their customers.  Inside these feeds are an enormous wealth of information.  In addition to quotes and trades, you get information on cancellations and revisions.  HFT’s will use this information to model past behavior in a stock to help predict future price movements.  Last year, we wrote a paper detailing how some exchanges were providing information on hidden orders which the client thought was private.  We highlighted two examples from the Nasdaq and BATS exchange.  At the time, we did not find any evidence of this going on at the Direct Edge exchange. Apparently, we missed this because on February 4th, Direct Edge made this statement:

“Members seeking complete anonymity for reserve orders can now request a new, randomly-generated order ID be applied to the replacement order for the replenished amount.  This option will remove the link between the original order and its replacement on the book feed.”  Basically, Direct Edge has been keeping the same order id number for every transaction related to your reserve book original order.  This has made it very easy for a customer with a direct data feed to reverse engineer the order id number  and gain valuable information which was supposed to be private.

Rather than cheering the NYSE/Deutsche merger for its cost savings and ability to be a global powerhouse, we think people should be asking why the NYSE and the stock exchange model has been a failure.  Why did they desperately seek out a partner? Will the same thing now also happen to our other stock exchanges? Stock exchanges are now just a place for HFT’s to play their liquidity vanishing games. The exchanges no longer provide any useful services to corporate issuers.   As the high frequency traders suck every last dollar out of our market, they are leaving behind the rotting carcasses of our once prestigious stock exchanges.  It’s time not to try to save this dying model by merger, but to save it by innovation.  It is time for us to rethink our market structure and reinvent our exchange model so that we can once again be proud to say that our stock exchanges are a place where companies come to raise capital.