May 8, 2013

Follow the Money

If you appeal a parking ticket to the Parking Department, what’s your expectation of objectivity? The Parking Department collects revenues.

Which brings us to word circulating last week from CEO Duncan Niederauer that NYSE Euronext and other exchanges are confronting the growing problem of off-exchange trading. “It impacts the quality and integrity of the U.S. capital market – and ultimately the ability of markets to enable companies like yours to raise capital efficiently,” Niederaur wrote in a letter to issuers (which a variety of alert readers passed along to me).

Shouldn’t we first ask why money has fled displayed markets? Private equity is working great. It’s a non-displayed market. Pensions and endowments have nearly twice as much money in private equity than public equity today. Investors aren’t forced to transact off the exchanges. They choose to.

Now exchanges want regulators to herd them back to displayed markets…for your good? Or for theirs? There’s a biblical proverb that says, “The first to present his case seems right, until another comes forward to question him.”

I think fragmented markets are a problem. But the reason the NYSE and other exchanges want trading between brokers to move back to exchanges isn’t for capital-formation purposes. It’s because the NYSE and other exchanges are data and technology vendors. NYSE Technologies last year generated $473 million of revenue supplying data, circuits and technologies to those trading your shares.

NYSE Technologies’ top clients are what it calls “systematic traders,” (high-frequency trading firms), broker-dealers, institutional investors, and market operators. Issuers? Nope. Move along, nothing to see here.

At NYSE Technologies under the heading Systematic Traders, there’s all sorts of information about how high-frequency traders can perform better with help from the exchange. Why there’s even a white paper called “Infrastructure Solutions for a Broader Spectrum of High-frequency Traders.”

So if the exchange wants to force more trading back onto its market, and it’s selling services to high-frequency traders…well, do the math. What do you suppose we’ll get? More capital-formation? Or more HFT?

Here’s the truth. To generate data revenues, the exchanges create multiple trading platforms with variable fee structures to encourage different orders at each – and that’s how we get statistical arbitrage. Then they sell data products and circuits to the traders. Plus, in order to earn data revenue from the consolidated quotation tape, SEC rules say they must quote a security 50% of the time between the best bid and offer nationally, and match 25% of the trades. Exchanges barely have total market-share anymore of 25% in the companies they list.

They are losing revenue. That’s why they want to force trades back to exchanges, under the guise of improving markets. Follow the money. It will always lead to the answer.

If this seems a scathing indictment, it’s not. The exchanges are competing with others like the London Stock Exchange, which owns GATElab and MillenniumIT, two of the premier global HFT technology providers.

But the problem isn’t dark pools. It’s a marketplace functioning like a giant Ethernet Wide Area Network. It’s all about stability and traffic flow. That’s why money trades in the dark. It’s avoiding an environment designed to move packets of data around for a profit. That’s not capital formation.

If we want investors to transact in displayed markets, we should make displayed markets appealing to them. In 1792, the 24 brokers meeting under a buttonwood tree in New York scratched out a two-sentence agreement to charge a minimum commission and to give each other preference. Simple. The NYSE. That structure worked, albeit imperfectly, for 200 years.

In the eight years since Regulation National Market System replaced that structure, we’ve got a WAN. Not a stock market. It’s a highly unstable statistical arbitrage device.

Maybe public companies and exchanges and investors should all get together, set differences aside, and fix this mess once and for all. We could, you know.

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