The Role of an Exchange


Earlier this week, BATS announced that the SEC approved their request to add another options exchange in the U.S.  This will be the second options exchange for BATS and the 13th options exchange in the U.S.  Unfortunately, this approval once again proves that regulators really don’t understand the problem that fragmentation has caused in our securities market.

Most likely regulators are still listening to the same industry folks and hired lobbyists who are telling them that 11 stock exchanges, 13 options exchanges and over 40 dark pools represent competition and that this competition has brought down trading costs.  Most likely these regulators didn’t read “The Arms Merchants” chapter of “Broken Markets” where we distinguish the difference between competition and fragmentation.  And most likely these regulators have not read the new paper just published by Norges Bank titled “Role of Exchanges in Well-Functioning Markets”.   In the paper, which we highly recommend that you read, Norges describes how the role of exchanges has changed in recent years and the challenges that this presents to long-term asset managers.  Norges questions whether or not the exchanges are properly performing their intended function:

“Exchanges are ultimately a key arbiter of prices in capital markets, acting in the interest of all investors – retail and institutional alike. In a sense, they provide a utility-like service to all participants in the economy, perhaps analogous with airports and motorway infrastructure. Unlike physical infrastructure, however, they have experienced a technological speed race almost unprecedented in any other industry.”

Norges notes that these changes have led to some worrying developments:

“This fragmentation and increased competition have led to some worrying developments for exchanges, broker-dealers and investors alike.

  • Intensified competition amongst exchanges and ATSs poses the threat of a regulatory race to the bottom. For-profit exchanges are now challenged to maintain their regulatory and corporate governance duties in this competitive landscape.
  • There is a risk of speed race to zero: investments both by exchanges – to cope with ever-increasing message flow, and by broker-dealers and market-makers/HFTs – to keep up in the speed race, have the potential to impose negative externalities on all market participantsThese externalities have the result of transferring an increasing portion of the profits from intermediation to entities outside the financial sector. For example, we are following the current speed race amongst microwave data-link providers with interest and believe that they are able to earn increasingly super-normal profits, to the detriment of all financial market participants. We support efforts to remove complexity that leads to this form of over-investment.”

Norges warns the exchanges that they need to continue to evolve since they view “the automation and latency reduction phase of exchange development as coming to a close”.  They urge the exchanges to develop new ways to address the liquidity concerns of the institutional investor which might include liquidity concentration methods such as intraday auctions.  They also note that experimenting with size vs time priority models and batch auctions might be good initiatives for the exchanges.  Bottom line:  Norges wants the exchanges to stop catering to the ultra-short term trader and start addressing the liquidity needs of the long-term asset manager.  We agree.