Save the Neutrality of Exchanges
Exchanges are bound by law to treat each market participant on an equal basis. Their governance models give them no incentive to favour certain customers or customer groups…
Exchanges are bound by law to treat each market participant on an equal basis. Their governance models give them no incentive to favour certain customers or customer groups.
But the advent of competition in the form of alternative trading systems, some backed by large market participants, means this basic tenet of market structures is no longer applicable across the board. Indeed, the hyper competition now existing in the American exchange environment threatens the health of these critical economic engines – the exchanges.
The critical economic role of securities exchanges, particularly stock exchanges, is that of efficiently allocating capital on behalf of those seeking an investment return to those individuals and corporations wishing to expand or develop new products.
Exchanges are the essential building blocks of America’s economic growth and a proxy for that growth.
The most important function of any securities exchange is that of establishing the price at which a trade will take place. All other services and offerings of an exchange, although necessary, are secondary to this “price discovery” process.
If this process is flawed, open to manipulation, or unclear, investors eventually downplay investing in publicly traded securities in favour of other, more transparent opportunities.
The price discovery aspect of our major stock exchanges was deemed so important that virtually all securities regulations for nearly 100 years strove to preserve the process. This regulatory focus addressed price manipulation, insider trading, full and timely disclosure, conflicts of interest, front running – that is, anything deemed to undercut the clarity and validity of the process and consequently, investor confidence in the system.
One area of conflict that existed with regard to major exchanges was their ownership by the traders and trading firms acting on behalf of themselves as well as public investors. As a result, regulation and compliance were always viewed as compromised. On occasion, that suspicion was justified.
This inherent conflict was, in great measure, removed as major exchanges demutualised and became publicly owned corporations, with their regulatory responsibilities segregated into independent entities. As a result, exchanges became truly unbiased trading venues.
Yet in the last few years, regulators and legislators appear to have lost sight of the importance of our exchanges, their function in mobilising savings and investment, and the confidence investors have in these institutions.
The legislative and regulatory process shifted focus to speed of execution and enabling as much competition as possible in order to reduce trading costs. Although these goals are valid, many fear the unintended consequences have seriously jeopardised the price discovery process.
Historically, price discovery took place in an open, auction environment where interested buyers and sellers met to establish the basis of a transaction. They are now scattered into numerous venues with varying degrees of transparency.
About 40 “mini exchanges” or Alternative Trading Systems or Electronic Communication Networks now exist in America. Many of these are controlled by professional trading entities. This effective remutualisation of the trading process has introduced many of the old potential conflicts whereby owners of these “exchanges” have a significant interest in obtaining favourable prices for their own trading operations.
Further, as larger orders are held back from the main exchanges, the price discovery process is “thinned out” with fewer buyers and sellers participating in the process. This opens the exercise to easy manipulation, in order to enhance trading profits to the detriment of public investors.
Many of the new trading platforms have cut trading fees to uneconomical levels. Whereas exchanges must maintain mechanisms for trading surveillance, alternative platforms are not burdened with the costs of these obligations. In fact, they receive a free ride in this area. This unlevel playing field could have a significant impact on America’s major capital markets over time.
Exchanges are also strictly neutral. Their governance models give them no incentive to favour certain customers or customer groups. Operators of trading facilities owned by large market participants may not have the same constraints. The open and visible governance of publicly owned corporations was one of the great reasons for demutualising America’s major securities exchanges.
The principle is simple: a cartel of brokerage firms should not control the nation’s equity trading markets or venues.
The legal and regulatory framework in which America’s publicly owned securities exchanges operate should emphasise and support their vital role in the economy, not weaken it.
America’s major stock exchanges were among the few financial institutions that continued to function throughout the recent financial debacle. One would hate to imagine what would have happened had they broken down.