A very good friend hit me up with an oh so familiar question the other day…”what would you do if a large incumbent exchange gave you the keys to the boardroom and let you run the show”? Easy right? Many of us have spent the last several years playing this game, and acing the exam. Eliminate rebates, reduce order types, homogenize data feeds, not be a complete prick….so many great answers to choose from. But of course this friend doesn’t ask easy questions, so i knew he was going to include a catch….you have to answer from the perspective of an actual exchange exec, not an exchange user, and thus are answerable to the board of directors and ultimately the shareholders. If the plan results in 20% lower revenues with no offsetting growth, you don’t last 6 months and have failed…a much tougher question.
As it turns out, the friend in question may in fact have this problem in real life in the coming months, so he isn’t just asking to indulge in group intellectual masturbation. He needs to discover if the problem has a solution, or is in fact a kobayashi maru, before making an important career decision.
As one considers the problem, you begin to understand the problem facing public companies of all sort who have danced with the devil. You know you should turn off the music and call it a night, but shareholders have fallen in love with the melody and don’t want it to end. In order to stop the dance you must find new music and a new dance partner that are equally pleasing to you audience. No easy feat. This is in fact the lone advantage of the upstart competitor. While they need to beg for connections and orders, they don’t have any bad habits that need to be broken. The marginal flow – often mis labeled liquidity – of the more elastic and predatory hft players is like cocaine. It makes you feel invincible, but actually makes you quite the opposite.
Anyone that has enjoyed Nathaniel Poppers’ brilliant Digital Gold can appreciate the unrestrained free form offered up to new entrants. Oh sure, you can’t enter a regulated market and just do as you please – right Uber? – but beyond the scope of regulation you are free to play. If you want to try no rebates you just do it. Yes the major exchange groups now have enough medallions they can play around with one of their junior markets, but even this comes at great risk. Suppose for example NYSE were to remove rebates from ARCA and it was highly successful? Do they dare move the experiment over to the main market? The flow that Arca has traditionally attracted is very different from the flow sent to the main venue….so the experiment may play out very differently the second time around.
After consideration I very much want to say that no viable solution exists. But this is a bullshit cop out. I have written too much, in too many venues to take that route. So I won’t take it. Instead I will offer up a a few ideas on how to grow revenues at the exchanges in a manner that at worst won’t harm clients and at best will be additive in nature. These solutions all have one common theme – take the exchange core compatency of matching buyers and sellers, and apply it to markets where entrenched incumbent intermediaries are charging over sized rents for similar services. Lets consider just a couple of such solutions.
1) FX – Go ahead and try to do a simple USD/EUR transaction at your local bank. The on sided quote will be 2%+ away from the reuters D2 rate on the best day. 2% will become 3% in times of stress. Why is this the case? Because the nature of FX trading, which doesn’t utilize centralized clearing systems, is extremely capital intensive and requires distribution. As such the retail banks own the game. Smaller players that have democrotized listed equity and derivative markets simply do not exist in FX. The rise of FX ECNs shows the institutional world is ready for electronic FX markets. The retail clients, who have been quietly getting their faces ripped off for years will eat this up. And it quickly eliminates the one fully legal purpose that bitcoin serves – reducing the frictional transaction costs. The trick is gaining distribution by convincing the retail banks to let clients transfer funds to and from the exchange – or in the case of vertically integrated models like Toronto, Brazil, Aussie or HK, to the clearing house. Not easy, but the right campaign using moral suasion and appeal to informed larger retail clients can get this done.
2) The single most inefficient market in the entire capital markets structure is the primary equity market. Hot issues like Shake Shak, Fitbit, Twitter and the like are routinely underpriced by the investment banks, to the benefit of their recurring trading partners and the detriment of the entrepreneurial issuers. Despite complete information about the order book, stocks like Shake Shak open up 50+% above the IPO pricing. The issuers are spun a story about the need for a bump to generate interest in future issues, but in truth the banks are lining the pockets of their largest trading partners in return for over sized allotments of trading flow. But an exchange, with its auction capabilities, that is able to effectively discover price on a multi billion dollar index rebal, has all the know how to more efficiently discover price on a new issue. Disrupt the primary equity market and entrepreneurs will face less friction in coming to market, and asset managers and pension funds will be incented to send flow to firms getting the best execution, not the firms getting the best issues. And best of all, allocations will be allotted on a best price basis, not on shadowy relationship, nod, winks and kickbacks.
If properly implemented these two fixes alone can generate significantly more revenue than will be lost by scrapping high speed single purpose feeds, rebates and hide not slide queue jumping order types.
But go through the exercise yourself. Imagine you have the job, and have to fix the exchange you have been complaining about, in a reasonably revenue neutral manner. Can it be done.
I would love to hear your thoughts