This question is not intended to be one more rant against the clubby nature of exchanges. Nor do we want to assail the methods of trading whether floor-based or electronic. The question is more fundamental. In an environment where exchanges compete with their members; where governments have appropriated listings; where the price of an execution is nearly free; and where the information byproduct has become a commodity, do exchanges matter any more? More significantly, would anyone want to invest in one?
In this article we will explore both the history of exchanges and their current state. We will also look at how recent changes, both economic and structural, call into question the need for and value of exchanges, as they are commonly perceived.
A historical perspective
Exchanges evolved as a location where those interested in buying or selling securities could meet physically to transact. Quickly, the need to settle disputes that arise in the normal course of transactions created the need for rules of trading to protect traders from one another. In time the need arose for regulations to protect innocents from professionals in order to keep the public willing to use the exchange for trading. Exchanges developed listing requirements that provided minimum attributes for securities that could be traded on the exchange. The listing requirements in turn provided a cachet of quality for the listing company that attracted investors. With the development of the stock ticker, exchanges were able to disseminate last sale information - market data - that served as advertisements for the market and provided transparency that made prospective investors comfortable with the fairness of the market. Finally, as the volume of trading grew, some method of clearing and settlement became necessary and the exchanges either provided these two facilities or served as the agency for finding others to provide them.
All of these services were provided in the form of a mutualised entity whose only purpose was to provide services at the minimum cost to the participants. Why a mutualised entity? Generally, the purpose of the exchange was to provide necessary services and then get out of the way. The notion was that the exchange existed to serve the membership at the lowest cost possible.
Recent changes
In the last several years a number of changes in the traditional exchange model have occurred. Not all of these changes have occurred in all markets, but it is fair to say that all markets have experienced some or all of these changes. In rough chronological order the following evolution of the historical exchange roles have occurred:
The end of exchanges as market data vendors
Beginning in the late 1950s technology firms emerged that collected information from multiple exchanges and provided this information through a single distribution mechanism. This was the end of exchanges as vendors. Exchanges that control important liquid markets continue to derive important revenue from selling information on the market through technology firms such as Reuters, Bloomberg and Thompson's ILX that consolidate and redistribute exchange quotes and prices.
The end of clearing and settlement as an exchange function
Early in the European markets and more recently in North America, exchanges either lost or surrendered their role in the clearing and settlement process as independent clearing and settlement entities were formed. Recently, exchanges are re-acquiring more of the clearing process (with its risks, expenses and liabilities) but not the more profitable settlement activities.
The end of the exchange as a physical location
Beginning with the Toronto Stock Exchange in the mid 1970s and increasing in frequency and scope, physical exchange floors have given way to automated trading systems. Many exchanges such as Toronto, London and Paris (now EuroNext) have closed their floors while many others trade both electronically and with floors.
The separation of regulation and trading
Beginning with 'Big Bang' in London and the subsequent evolution of the FSA many of the traditional self-regulatory functions have been lost by the exchange proper. More recently, the NASDR has taken the regulatory functions away from Nasdaq, and the Arca Exchange bought the execution functions from the Pacific Coast Exchange, but left the regulatory functions with the exchange.
The diminution of importance of listings
With the creation of the FSA, the traditional role of listing has begun to migrate from the London Stock Exchange to the regulator. To be sure there is still the sense of listing at many exchanges, but one can foresee a time in which listing represents adherence to governmental rather than exchange function.
What do exchanges do?
Each of the trends mentioned above suggests erosion in the importance of the exchange's role - the functions they perform. To explore this more fully it is important to understand why we have exchanges from the perspectives of six important stakeholders of exchanges. These groups are:
- Exchange management and the staff;
- Members or those permitted to transact directly on the exchange;
- Stockholders or those interested in the revenues of the exchange;
- The investing public, both individuals and investing intuitions;
- Listed companies; and
- Regulatory authorities on behalf of the general public.
We will look at each of these in turn.
Exchange management and staff
Generally exchange managements and staff view exchanges as institutions to be aggrandised, expanded and enriched in stature, power and wealth. If the exchange is or anticipates becoming 'for profit' this view is magnified by the potential for the management to cash in stock in the public entity. The staff often finds its goals for the exchange in conflict with those of the members/traders whose only interest is facilitating low cost execution.
Members or those permitted to transact directly on the exchange
Traders view exchanges as utilities that exist to provide services - execution and clearing - at the lowest cost possible. The narrow focus of traders sometimes causes them to be shortsighted with respect to the best interest of the exchange as an institution and even their own long-term interests. Nevertheless, traders force exchanges to focus on their primary purpose of facilitating trading. When exchanges forget this purpose, they often get into trouble.
Stockholders or those interested in the revenues of the exchange
When an exchange becomes 'for profit' the best interest of the exchange becomes more clouded. There is a natural conflict seen in businesses of all types. In the case of exchanges, raising prices increases the revenue per trade. Alternatively, the exchange can keep prices low in the hope of attracting order flow. Unfortunately, there is little evidence that keeping execution costs low can, independently, attract order flow. By contrast, there is some evidence that when prices get out of line order flow deserts the high-priced market.
The investing public, both individuals and investing intuitions
Investors are primarily interested in ensuring that the market is fair. Fair does not mean that all participants are treated equally, but rather that differences in privilege are the result of services contributed to the market. Investors do not generally care who ensures fairness, but if they perceive that the fairness is lacking they generally abandon the market.
Listed companies
First, listed companies choose to list on an exchange, or exchanges, in order to find a liquid market on which the securities can trade. Secondly, the company wants the 'seal of approval' that trading on a well regulated exchange provides. Tertiary benefits arise from exchange rules that help stabilise price moves in the company's security (or securities).
Regulatory authorities on behalf of the general public
Regulatory authorities are generally interested in protecting their primary constituency - their local public. Protecting the public from unscrupulous professionals and those who would defraud innocents promotes both the image and reality of fairness. For many countries there is also a national pride element that is a secondary goal of having liquid, respected markets.
But what do exchanges do and how are they paid?
These descriptions speak to expectations from various constituencies of exchanges, but they do not answer our original question: 'What do exchanges do?' To summarise the functions of exchanges, we need to address our question in two important ways. The first of the questions is: What do exchanges do to satisfy the constituencies listed above? The second question is: What are exchanges paid for doing? This distinction will prove critical to our ultimate question of whether exchanges are necessary.
Exchanges are expected to do four or possibly five functions:
- Exchanges manage fair, efficient and orderly markets;
- Exchanges regulate, or oversee the regulation of, the market in such a way that professionals can transact sure in the knowledge that their trades will be fairly managed. The exchange must satisfy the public and regulators that investors and non-professional traders are treated fairly;
- Exchanges create conditions that convince listing companies that the exchange is a good market for listing. Companies must be convinced of the benefits for the stockholders needing to buy and sell shares. The firm also wants to enhance the reputation of the company. Complying with tough listing requirements can foster a reputation for integrity;
- The exchange is charged with disseminating information about the market in order to attract order flow and increase the perception of openness or transparency; and
- Finally, the exchange may be directly involved in clearing, in order to provide services necessary for trades to be cleared and settled.
To manage the markets and to operate the systems and facilities that support trading, markets generally charge for all executions that are effected in the market. However, traders are unwilling to pay for more than the cost of the execution. It is difficult to see how exchanges, unless they become protected monopolies, could ever charge enough for transactions to create attractive revenue streams.
Regulation of the markets is critical for the reputation of exchanges, to facilitate daily trading and to persuade would-be traders and investors to use the exchange. However, it is difficult to find any effective method to pay for these services even though they represent a significant portion of the costs of an exchange. Therefore one of an exchange's largest costs must be paid for out of other revenues. Outsourcing can shift the burden to other, presumably more efficient, entities, but costs must still be paid.
Listings are a very lucrative source of revenues for those exchanges that serve as a market of original listing. Companies pay significant fees to have their securities listed on the most important and prestigious exchanges. However, several issues cloud the revenue potential for listings. First, an exchange must be a preeminent exchange to charge for listings. Second, the current bad market has shown that companies withdraw from secondary (i.e., on other than their home market) listings when volumes decline. Finally, there is some tendency for national regulators to assume some of the functions associated with listings and we can foresee a time when exchange listings (and thus revenues) will diminish in importance.
Market data has been a great source of revenues for exchanges and has been resistant to downward price pressures that have caused many market data vendors to become less profitable. Pricing pressure on exchanges has had little impact because of both the lack of competitive sources for the information exchanges provide and, in some cases, of data collection and distribution consortia (e.g., the Consolidated Tape System and Consolidated Quote Systems for US equities and the Options Price Reporting Authority for US options) that protect the member exchanges from price competition. Nevertheless, two trends could end the price stability enjoyed by exchanges. First, prices and quotes are less important to traders and investors than they once were. Those exchanges that provide electronic trading systems provide market information that is 'actionable' (i.e., the quotes can be hit by the viewer) as part of the trading system. This diminishes the value of quotes distributed through traditional vendors. Second, traders and dealers are able to 'shop' their executions among markets for reporting purposes. Recently the Island ECN in the United States began printing its trades in Nasdaq listed issues on the Cincinnati Stock Exchange instead of through Nasdaq. These factors suggest that the insulation of exchange revenues may be near an end.
Finally, to the extent that the exchange is directly involved in clearing and settlement, it receives fees for that purpose. These fees are generally kept as low as possible to facilitate trading rather than as a source of significant revenues. It is important to distinguish between the clearing process that involves resolving errors, netting positions and ensuring the settlement process. These activities are not profitable and incur substantial liabilities. Increasingly even in those markets where there is a separate clearing corporation and/or depository, some clearing functions are being pushed back to the exchanges because the functions are costly and because exchanges are better positioned to manage the functions. Settlement, and in particular the depository function, can be very profitable because of the funds float that can be available. Unfortunately exchanges do not typically participate in activities that generate these revenues.
In summary, exchanges may have as many as five sources of revenue. Three of the five typically are priced to cover the costs of the function that is is performed. Raising the prices for these functions risks driving traders elsewhere. The two functions that have attractive revenue streams - listings and market data - are vulnerable to both price and service competition. Moreover, there is the risk in some markets that the regulatory authority may assume the role as the listing authority, while traditional market data is declining in value. Balanced against this, regulation - a major cost area - is increasingly expensive and is difficult to charge for directly.
But do we need exchanges?
The analysis in the last sections suggests several fundamental questions: Why would anyone consider investing in an exchange? Put differently, for an exchange to do its primary functions very well, could it be necessary that the entity be mutualised among those who benefit most from its services? Finally, if the exchange attempts to profit from the services it provides, does it create a natural incentive for the traders and listed companies, on whom the exchange depends, to search for or create a less costly competitor?
As we said at the beginning, the goal of this paper is not to pillory exchanges. In asking if we need exchanges we are suggesting that exchanges that are for profit may be dysfunctional and self-destructive. Exchanges have a fundamental conflict between their shareholders and their primary customers, the professional traders and listed companies. It is true that all companies have conflicts between owners who want revenues to be as high as possible and customers who want the cost of the products and services they buy to be as low as possible. The difference is that a simple execution - matching an order to buy against an order to sell - is the least differentiable service we can conceive. The true value and quality in an execution is provided by the traders themselves, who bring their liquidity to the market, and not by the exchange itself.
Our purpose therefore is cautionary. There is no need for exchanges unless they provide services better and more efficiently than alternatives. All of the functions exchanges provide could be, and in specific actual instances are being, provided by entities other than exchanges:
- Brokers such as ECNs and dealers such as market-makers provide execution. Moreover, brokers and dealers are more profitable than exchanges can be because at any feasible price levels it is more profitable to charge 'cents (or pence) per share' as brokers do, rather than 'dollars (or GBP or EUR) per execution' as exchanges do.
- National regulators can regulate markets directly. The role of self-regulation is not conveyed by holy writ. It is simply a regulatory sanction of a pre-existing practice.
- National regulators could also offer the requirements for differing levels of security quality. In fact, as multiple listing across national borders grows, this may become necessary.
- Any number of schemes could be devised to create market transparency. These schemes do not require exchange participation. Perhaps the best examples are CTA and OPRA, which are exchange owned, but could just as easily be mutualised monopolies.
- Clearing and settlement is in many markets distinct from the exchange.
In short, if exchanges do not perform their primary functions well they can be replaced, and serving as 'for profit' entities may not be consistent with doing their functions well.