Following a trend begun by an earlier new exchange, IEX – also designed to compete with the Big Three (NYSE, NASDAQ, CBOE) – the shares of the new exchange, MEMX, are not for sale. The new exchange will be controlled by its incumbent owners. In my first MEMX article, I pointed to the absence of any contribution to the overall financial market structure in the MEMX business plan. Reducing fees, as MEMX plans, can at best have only one beneficial effect, a reduction in overall broker-dealer costs perhaps passed through to trading customers as well. But MEMX was not content with a simple reduction in exchange fees.
Had MEMX left its contribution to reduced fees only, the arrival of MEMX would have been boring, but useful. But MEMX went much further. They are going to put their ability to stay in business without making money to use by changing the one fee that directly improves the value to broker-dealers of using MEMX. They are going to subsidize market-making.
This article examines some unintended perverse effects of MEMX’s decision to use its fee structure to change the relationship between the cost of market-making and the other fees the Big Three assess users. The MEMX decision not to meet the market test of its value by permitting its shares to trade publicly became a necessity when MEMX beggared itself by subsidizing the market-making function.
But MEMX will discover that it cannot thwart the economic behavior of market participants in the long run. The members of MEMX may be surprised and disappointed by the results of this subsidy of market-making.
Exchanges place themselves above the market fray.
There is little public discussion of the awkward paradox of new exchange avoidance of market valuation. Stock exchanges’ fundamental function is to facilitate market forces determining securities values, thus assuring that the benefits of corporate ownership accrue to those who value it most. Yet these new exchanges eschew market determination of their own value.
However, the underlying economic forces driving the value of exchanges themselves will still be fundamental to the contribution of exchanges to trading efficiency. The market-maker subsidy will ultimately have to go. MEMX will not be able to afford it.
There are two ways MEMX may improve the lot of the trading public. MEMX may improve trading technology, thus capturing value by taking a share of the current value of overpriced incumbent exchanges. Or MEMX will reduce the cost of trading for one sector of the trading establishment, at another sector’s expense. The second outcome is a strong possibility that may not be MEMX’s intention. The membership of MEMX will subsidize the market-making activities of non-members, leading to a short-term rearrangement of income in favor of market-makers off the MEMX ownership rolls.
Why avoid the market pricing of MEMX’s own shares?
The primary conclusion of this article is that MEMX, like IEX, may survive; but will not achieve the ambitious goals of its new owners. MEMX will not reduce the costs to broker-dealers of exchange trading, including fees paid to exchanges, and will not dislodge the incumbent big three.
This article first explains the source of new exchange decisions not to permit their own markets to determine the values of these exchanges themselves. In other words, why the new exchanges will not take their own value-driven medicine.
How NMS defeats inter-exchange competition
The new exchanges address a very real failure of the Big Three exchange marketplace providers, the direct result of the SEC’s well-intended but disastrous National Market System (NYSE:NMS).
In earlier articles, here and here, I describe and discuss the strange behavior of the incumbent Big Three EMFs.
To summarize that discussion. The key flaw in the SEC’s NMS is that it seeks to establish two mutually contradictory outcomes. It seeks to foster competition between the exchanges in providing trading and clearings services, on one hand. On the other, it seeks to prevent the pre-NMS pattern of trading – to wit, to prevent the exchange monopoly outcome. Before the advent of electronic trading, each stock had value determined by traders at a single exchange, an apparent trading monopoly.
Electronic trading did not change the efficiency of a single monopoly market, but it did permit the SEC to encourage inter-exchange competition through NMS. The contradiction is that a marketplace divided is always a less efficient source of liquidity than a single market. Efficient trading demands a monopoly. The SEC cannot have both efficiency and competition among exchanges.
But the SEC could not have anticipated the absurd result of NMS – that a dominant exchange like NYSE will seek to create clones of itself. Why do exchange management firms create these clones? The NMS requires that broker-dealers obtain the best price for a customer order. This creates two problems for broker-dealers.
To find the best price for every transaction, the broker-dealer must know the most recent price on every exchange, all the time. The price of knowledge of the best price is the collocation fee, the cost of instant knowledge of the price on any specific exchange. Since the exchanges charge collocation fees, fees for location adjacent to the exchange computer, every significant broker-dealer must pay collocation fees at every exchange. Whatever the collocation fee, broker-dealers must pay all SEC-approved exchanges for the collocation service. The exchanges have every incentive to boost these fees to a maximum. Moreover, the collocation fees collected by a Big Three EMF are directly proportional to the number of clone exchanges the EMF has. EMFs have an incentive to own as many clone exchanges as possible – if I own four exchanges, I receive four collocation fees even though each order is placed on only one.
The absurd real-life result is that the Big Three together own 12 clone exchanges. “The better to soak you with, my dear,” says Grandma Wolf.
The key questions MEMX does not answer.
The key question with a missing answer is slightly different from the question MEMX answers in the affirmative. MEMX clearly does charge lower fees across the board than do the Big Three. But that is not the relevant question. What matters is the total effect MEMX has on the fees paid by broker-dealers to all exchanges combined. The answer is found by a look at three different exchange fees: collocation, maker-taker, and Market on Close (NYSEMKT:MOC) orders.
- Collocation. No effect. Collocation is free at MEMX, but the broker-dealers are still obliged to pay collocation fees at the Big Three’s 12 exchanges, as before, plus any new fees charged by other new exchanges. In other words, the existence of an exchange that does not charge for collocation does not reduce the fees broker-dealers pay to the other exchanges.
- Maker-taker. Uncertain effect. Market makers seem to be correctly incentivized by MEMX’s willingness to execute orders at a loss. It is efficient to make a better market at MEMX (higher bids, lower offers) than at other exchanges. At first blush, this looks like a great opportunity for MEMX to take market share.
Moreover, the SEC will welcome this competitive behavior.
However, there is a circularity in the MEMX notion of operating an exchange at a loss to ownership. Did the leadership of MEMX consider which firms will benefit most from subsidized market-making? A MEMX subsidy of market makers is provided by MEMX owners, ultimately. Yet the owners of MEMX are market-makers themselves. Since most owners of MEMX are themselves market-makers, it might seem that MEMX owners are simply passing loose change from their right exchange-owning pocket to their left market-making pocket. But that is not what will happen.
A larger problem for MEMX’ owners – market makers that are not MEMX owners will now be subsidized by MEMX owners. Not only will nonmembers reduce their bid-ask spread, but they will be paid by MEMX members to do so. As a result, the profit-maximizing bid-offers of non-members will be tighter than that of members. Thus, in equilibrium, only non-members will take advantage of the attractive MEMX maker-taker fees while members pay the entire cost of providing them.
This surprising decision of MEMX members – major broker-dealers focusing on existing costs and taking brute force measures to reduce them – is not the only time reactionary decision-making was the hallmark of the old-line exchange community. It took several years, and the Johnny-come-lately firm Island, to bring electronic trading from the futures markets to the stock exchanges.
Somebody small and agile seems always to find a way to profit from broker-dealer hubris. Smaller firms have driven every significant innovation of the past 50 years, beginning with CME (CME Group) initiatives (financial futures, electronic trading, for-profit exchange management), AMEX, Vanguard, BlackRock (ETFs), and Island and Archipelago (Electronic stock trading).
- MOC. Negative effect. This is the ultimate issue that will determine the outcome of the Big Three EMF confrontation by MEMX. Under the status quo, which has CBOE suddenly sharing in the MOC income from the listings of NYSE and NASDAQ as explained here, has secured CBOE’s inclusion with the other Big Three EMFs at the MOC exchange fee trough.
The inability of MEMX to compete in listings opens the door for a further increase in MOC fees at the Big Three exchanges.
As the volume of intraday trading shifts to MEMX, there are several numbers to watch. First, the cost of MEMX subsidies borne by its members. Second, the decline in the volume of intraday trading of the Big Three. Last, the proportion of Big Three volume traded at the close.
Look for the Big Three to expand the ways that listed firms benefit from their remaining strength, listing. One possibility would be to establish a series of MOC-like auctions during the trading day.
The most interesting question following the MEMX introduction is what smaller dark horse firms will do to grab the opportunity that the coming chaos will create.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.