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Warring States Period, Finding New Equilibrium, By Kelvin To, Founder And President Of Data Boiler Technologies

Date 09/07/2019

Kevin_To

The more firms joining a new exchange venture, the higher the utility values of this new trading network. Thus, MEMX has every reason to rally about it and it puts pressure on the existing big Exchanges. Shall NYSE, NASDAQ, and CBOE want MEMX not be formed in order to avoid competition? Then they will have to provide additional privileges to negotiate. This creates an interesting dynamic for those non-MEMX market participants. Let’s see what strategies they can pursue amid fight between MEMX and the big Exchanges:

(a)     Join MEMX to tip the scales

(b)    Follow MEMX’s tactic to ‘start’ another rival Exchange (MIAX)

(c)     Rise in the rank as NYSE, NASDAQ, and CBOE’s favorite customers

(d)    Help grow IEX, Luminex, OneChronos, IntelligentCross, LTSE, etc.

Firms pursue option (a) better hurry because existing core members don’t want to dilute their interest when there is already critical mass. They won’t need you or they won’t reward you sufficiently if you can’t bring enough order flow. Besides, you want to ensure a board seat at MEMX, or the expected promise of 32 mils super tier privilege won’t last long because MEMX may pull the plug anytime the big Exchanges agree to give them a big concession or buy them out (e.g. NYSE buying ARCA, NASDAQ buying Instinet, CBOE buying BATS, etc.).    

Goldman Sachs, BlackRock, Citigroup, JPMorgan, State Street and the like sized firms can definitely help MEMX tip the scales. Why would they do that if pursue option (b) together is a better choice. Being MEMX’s frenemy may have several advantages. First, it’ll send a clear signal to the SEC that theirs and MEMX members’ vested interests can’t be touched. Second, it’ll force the big Exchanges to renegotiate or possibly surrender. Third, through divide and conquer, the new rival and MEMX may establish new equilibrium for the securities markets (e.g. via ‘trade-at’ in favor of lit over dark venues if there are moneys to be divide up). Forth, the investments to patch up legacy Exchange’s old technologies could be a bottomless sinkhole. By replacing bet under a new brand with fresh technologies, the new rival would differentiate itself from MEMX’s vanilla model and earn more than their current stake in affiliated trading venues, including ICE-NYSE. Nevertheless, given MIAX has declared intent to start an equity Exchange, option (b) group can work with MIAX’s partners - Susquehanna, Two Sigma, IMC, Simplex, CTC, and Hudson River to build a safe and sound new business model that they’ll be willing to participate and invest.

With regards to option (c), - GTS has been a NYSE designated market maker since 2016 and this HFT’s key value proposition is about bringing new companies to list; they are one of the most favorite customers of NYSE and NASDAQ. However, CBOE BATS may not like them given the controversy of BZX alternative closing process. How would that shift the market focus if the existing big Exchanges join force with GTS and a list of foreign banks (e.g. Deutsche, Credit Suisse, Barclays, Mizuho, Société Générale, Natixis, RBC, CIBC, Scotiabank, etc.)? What does that mean for LSE, TMX, Euronext, etc.? Putting aside thoughts on possible global Exchanges integration, I think it is a good value proposition for two of the big three to become watchdogs guiding trading behaviors of the international community. That’s helpful from the regulator’s perspective because protecting the long-term interests of the (U.S.) main street investors is the SEC’s priority goal per FY18-FY22 strategic plan.

In my humble opinion, there are two viable paths for the big three Exchanges: (i) renegotiate with MEMX and others after winning the lawsuits against SEC’s access fee pilot; or (ii) withdraw the lawsuits and embrace the change. Unlike IEX with insignificant market share thus far, MEMX alone isn’t dismissible. Given the law of large numbers never loses, and patented algorithms allowing HFT systemic internalizer to avoid toxic / unprofitable trades, MEMX surely can draw massive orders away from the big three under the order protection rule against ‘trade-throughs’. By adding option (b) group to tip the scale or to form another rival, it would be naïve for the big three to undermine competition arising from the world’s largest financial institutions. So, watch out if MEMX core members and/or firms in option (b) group may play hardball in renegotiation. In that case, the big three may present themselves as loyalists to the SEC by withdrawing the lawsuits, call the rivalries as rebellious, and maintain appropriate balance in the public stock market. In turn, there may be some great rewards if they can build the next-gen surveillance tools and help support the SEC’s and FINRA’s mission to regulate the market.

Moving on to option (d) – grow IEX, Luminex, OneChronos, IntelligentCross, LTSE, etc. These venues serve solely or mainly the Buy-side, pensions, and prop traders. For those subjected to the SEC’s best execution requirements, they may despise the idea of having a possible 14th or more equity Exchanges because of the added market data and connectivity costs. Some may even think the U.S. should be like other countries that have one centralized exchange. In short, competition brings down costs and bureaucracy. An enormous Exchange can result in corruptions and other undesirable outcomes, e.g. susceptible to cyberattack. Anyway, I do like seeing this group of players grow, but the question is how? I presume IEX championed the lobbying effort to go against HFTs and/or the big Exchanges, but I hope they’ll go back to their technology root (which I applaud the ingenuity of THOR solution when they were at RBC). Just my two cents of suggestions, the rise of OneChronos and Intelligent Cross are more of a threat to IEX than the big Exchanges because they essentially go after the same market segment. So, why don’t they join force to help revive active management? Imagine having Capital Group, Interactive Brokers, Point 72, MassMutual, the Silicon Valley, and other prominent players such as DRW Investments and/or Wolverine Trading as backers supporting a cost competitive infrastructure. I see tremendous potentials if they can consider the futures and derivative markets as their primary battlefield, and then develop “complex strategies cutting across traditional asset class barriers”. It’ll be an interesting match-up against MEMX and others, and where I said – may the responsible use of A.I. prevail!

As a wrap-up thought, I think the spontaneous pop-up of new trading venues help smooth the markets and create positive tension among constituents. Technical fine tuning of the NMS plan is required, but one should keep in mind the fundamental functions of a public stock market:

  1. Market is a place where diverse parties come together to discover price.
  2. By having an efficient and effective way to delineate rights through stock trading, resources are pulled together and deployed, rather than withheld by mistrusted parties.
  3. Public stock market is an open system allowing participants to trade under ‘free will’, with the belief that it will yield better productivity, GDP growth and wealth creation than ‘planned economy’.

That being said, the idea of having diversified trading venues working harmoniously as one under NMS has it merits. I despise ‘Everybody owns, nobody owns’. Whether the market can fix the market itself depends on policy makers’ willingness to adopt our unorthodox idea in asking the Exchanges to spin-off data and technology business. By better delineation of rights, the separation would replace undesirable outcomes of a distorted economy of scope with efficiency gains in capital formation (see this for further explanation).

In the next article, I’ll discuss different phenomenon resulting from a dysfunctional public stock market, and pin-point problems about stock ownership ‘rights’. Stay tuned.