The Cure For Stock Market Fragmentation
The WSJ has an op-ed today titled “The Cure for Stock-Market Fragmentation: More Exchanges” which was written by Jonathan Macey (a Yale law professor) and David Swensen (Yale’s Chief Investment Officer). The article tackles what we believe is the number one problem with the US equity market: fragmentation. The authors sum up this problem in a paragraph that we think every investor and regulator should read:
“This fragmentation degrades market quality as trades are scattered across multiple venues and investors lose opportunities to interact directly with one another. It also creates arbitrage opportunities that did not exist when trading markets were unified. Transparency disappears behind a shroud of complex order types executed on vaguely sinister dark pools, trading venues that sometimes are used to disadvantage long-term investors.”
The article has a creative solution to the equity market structure problem of fragmentation: only allow stocks to trade on one exchange but have multiple exchanges compete for listings. The authors propose:
“The remedy is to create multiple trading venues and then limit trading in a particular security to one of them. There could be 10 licensed stock exchanges, and they could split among them the approximately 8,000 companies whose shares trade publicly in the U.S.”
We think the authors have hit on a key point here: stock exchanges should be treated more like utilities than profit centers. Prior to the demutualization of the NYSE and NASDAQ in the early 2000’s, trading at stock exchanges was more of a utility business. Exchanges focused more on winning IPO’s and servicing public corporations since they had a monopoly-like market share in their listed securities. This all changed after exchanges went for-profit and regulations enacted over the past twenty years forced exchanges to change their business model. Rather than focusing on serving their public company clients, exchanges shifted gears and began focusing on their largest trading clients. To profit from these high volume clients, exchanges changed their goals and created new revenue centers based on data – colocation center rent and the sale of proprietary data feeds are just two examples of these new revenue centers. Exchanges lost sight of one of their main purposes which should be to aggregate liquidity and have all different types of investors interact with this liquidity without being disadvantaged by “special deals”.
We agree with this statement from the authors of the op-ed:
“Understanding the markets is critical to fixing them. Our recommendation would increase market depth and liquidity, eliminate deadweight loss from arbitrage by HFTs, increase transparency and return competition to secondary market trading in equities. The U.S. needs more trading venues like the Nasdaq and the Big Board, so that even if these venues have monopoly power in individual securities, competition among exchanges for existing and new listings will keep costs down and foster innovation.”
While the authors didn’t touch on how they would handle dark pools and payment for order flow in their proposal, we think this op-ed is another important step in the market structure debate and are happy to see some new voices enter the arena. We are sure that the status-quo market structure crowd will try and debunk this article and will likely try to nitpick a few critiques in the article which were pointed at high frequency trading. Don’t let this status-quo crowd distract you from the main issue here which is how we can begin to glue back together our equity market so that investors can once again access diverse, deep and stable liquidity pools.