Do We Need Stock Exchanges?

Andy Kessler wrote a provocative editorial today in the WSJ.  It talked about how technology has made the stock exchange meaningless.  He makes some great points, but there are some points that really need more elaboration and thought.

The lens that he uses is the pending merger between the NYSE and Deutsche Borse.  There is a competing bid from NASDAQ/ICE.  I am not going to delve into the specifics of those bids.  That’s up to shareholders to decide.  What strikes me as odd is in this day of crowd sourcing, social media, and openness the NYSE Board is trying to close down the dialogue from NASDAQ/ICE to NYSE shareholders.  Seems to me the more talking that went on, the higher the bid.  Isn’t that what it’s all about?  Let the shareholders decide.  They will know better than management what’s best for them.

Kessler looks at the structure of the SEC regulated stock exchanges and concludes that they are in existence purely because of regulation.  In some sense, he is correct, in others I might disagree.

“Stock exchanges make a killing—easy, risk-free profits. They charge listing fees for the privilege of having shares trade on the NYSE—though the assumption of quality for NYSE-listed stocks that have included GM, Fannie Mae and Freddie Mac, Lehman, AIG and Enron is tragically dated.

Then there’s market data fees, a charge for your own and other’s trade data sold back to you. Add to that technology fees for the right to hook up to the exchange. It’s an amazing racket and makes up for trading itself not making much money anymore (which is why Wall Street firms took up creating and eventually owning derivatives).

Check out these numbers. In 2010, the NYSE received $422 million in listing fees and another $373 million in market data fees, which just about equaled their operating income for the year. But here’s the rub: The NYSE doesn’t even trade half of NYSE-listed shares anymore. Five years ago, they traded 70% of listed shares; today it’s 36% and dropping, the difference made up by BATS Exchange, Direct Edge and other alternative trading platforms, including Nasdaq.

Nasdaq’s numbers are similar. Market share of their listed stocks was 90%-plus in 1998 and is all of 27% today. No one’s quite sure what they’re getting for those listing fees anymore, when so much of the trading takes place elsewhere. But without them, there is no exchange, no matter who owns it.”

Market data is a profit stream for any exchange.  Look at the books.  It’s expensive, and it also props up an entire industry.  Companies like Bloomberg and CQG would be radically transformed and might even go out of existence if the cost of exchange data went away.  But, since people are willing to pay for the data, there must be some value in aggregating it.  Exchanges invest big money on systems designed to get quotes out to the market place as quickly as possible.  This is transparency.

The fact that this data can be readily consumed as fast as it comes out makes supply and demand forces work better.  Markets can allocate capital more efficiently and better because of good data.

Dark pools don’t provide any data.  Investment banks that trade against their customers are quiet about what goes on. This is lack of transparency.

As for listing fees, they do seem like a large cost that shouldn’t be there.  It always made my brow furrow when I had to pay a listing fee to another company when my company was providing the chance for the other company to make money.  It can’t be expensive to list stocks, and as Kessler points out, just because a stock exchange gives a seal of approval doesn’t mean the company isn’t run by a bunch of shysters.

The real issues with stock and commodity exchanges is the regulatory system that has been lobbied into place to oversee them.  Joseph Kennedy was the first SEC commissioner.  Urban legend has it that FDR made Joe the first commish because he knew how all the crooks worked, since he was the biggest thief himself.

I disagree with Mr. Kessler on this point.  Some kind of centralized market is the best way to allocate capital.  It doesn’t have to be an actual exchange floor, and already it’s being done by computers.  But there has to be a centralized network for price discovery.  The problem with today’s markets, especially on the SEC side is that they are so opaque, so rigged, and have so many regulatory licenses to steal that it’s not a flat, horizontal system.

We have a three tiered distribution system in stocks.  Main Street never gets the best price. The bid ask spread looks like it’s priced in pennies, when in fact the pros that trade know that it’s not.

Nefarious practices like payment for order flow screw up incentives in the marketplace.  If stock exchanges were allowed to clear their own trades and were responsible for price settlement each and every day, the back office of the exchange would become more efficient turning operational cash efficiencies back into the marketplace.

Events like the Flash Crash were not caused by electronic trading or markets being too fast.  Especially since mini-crashes have happened continually in certain stocks or segments of stocks every month since. The Flash Crash was caused by fragmentation.

The volume going away from exchanges is less a sign that they are not relevant, and more a sign that regulations have allowed a structure to develop that is not optimum to a fair and transparent marketplace.

Make every market participant compete on a level playing field.  Force them to show their size, and price report every trade (including block trades) immediately.  What you will find is that one electronic exchange will figure out a way to congregate all the liquidity in one place.  Competition will be intense, and actual risk transfer and capital formation will be done-and it will be done far cheaper than it is today.

The guy in the colored jacket screaming and yelling has gone the way of the dinosaur indeed.  But, the idea of a centralized marketplace that has intense competition and price discovery transmitting valuable information to the world has not.

UPDATE

I thought this chart was interesting when you looked at S&P, and exchange valuations.  The return on the S&P this year is +12-14%.  The return on exchanges varies, from CME’s negative 9% to NASDAQ’s plus 29%.

CME Group Stock Chart by YCharts

tip of the hat to Abnormal Returns, thanks for the link!


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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