Building the market of the future
Traditionally exchanges have been monopolies. They were owned by their members, blessed by governments, and acted like utilities. The cost of building a market center, developing a network, and gaining critical mass virtually ensured an exchange’s success. The more liquidity an exchange attracted, the more critical it was to trade there. This created a virtuous cycle where the big got bigger and the small became irrelevant. For decades this allowed larger exchanges to operate virtually unopposed, as they may as well have carved the adage “Where Liquidity Begets Liquidity” on their marble cornerstone.
In the late 1990s to mid 2000’s the game changed. Born of scandal, weaned by regulators, nurtured by consolidation, and catalyzed by Moore and Metcalf’s laws (increasingly less expensive and more powerful technology and networking) suddenly both the thought and reality of a unified centralized exchange seemed as quaint as folks gathering around a tree to trade.
While advanced trading technologies have increased efficiencies, reduced cost, increased volumes, and have generally been perceived as being good for investors (up until May 6, 2010), the same many not be true for exchanges. Suddenly traditional exchanges’ high entry barriers were breached and threatened by upstarts with a fraction of their overhead and more modern technology. Many exchanges were caught flatfoot.
Exchanges that were defined by time, brand and captive liquidity suddenly realized their liquidity was portable. A new bread of customer flow (buy-side algorithms), market makers, and high frequency traders (HFT) proved this all too well. Trading algorithms are more about here and now liquidity and less about people, time and brand. Machines are attracted by who has the best price now; and we are not talking about minutes, seconds, or even tenths of seconds – we are talking about milliseconds, microseconds, and soon be nanoseconds.
As liquidity increasingly becomes governed by machines measured in microseconds, exchanges will have an increasingly difficult time building a sustainable and differentiated business model. How do you develop a competitive exchange, if the competition can instantaneously copy your market structure, pirate your pricing model, and virtually eliminate any liquidity barriers? In this environment it becomes difficult to create competitive advantage and stop market share equalization, which is fine, if you are the upstart, however if you are the incumbent this race quickly drops from 100%, to 50%, to 33%, to 25%, to 20%, with the entrant of each competitor.
In an age of algos and HFT, can market share be protected? Can a differentiated business model be developed? Can exchanges, or upstarts for that matter, create something truly unique?
To answer that question we need to look at how business models can be protected, and how barriers can be erected and defended.
Exchanges have traditional protected their business models in multiple ways: community, product, clearing, technology, market structure, pricing, and regulation.
Many of these barriers are unfortunately lower then they have ever been. Product differentiation is difficult when products (equities and equity options) trade freely across exchange. But that is not universal. A number of exchanges have cultivated unique products and protect them through intellectual property rights tools (patents, copyrights, trademarks and licensing agreements). While traditional cash products are hard to license, the derivative exchanges have been successful keeping a number of their products unique.
Clearing efficiencies can create business-model barriers depending upon whether clearing and trading can be tightly linked. In the US, equities and options clearing has been centralized making it difficult to create differentiated efficiencies; however, the CME has used clearing as an effective tool to maintain market share. In Asia, trading and clearing has been generally been vertically aligned; the situation in Europe is more mixed. Some markets such as Germany have integrated trading and clearing (Deutsche Börse/Clearstream), some have horizontal clearing (LSE and NYSE Euronext clearing equities at LCH Clearnet), and some are horizontal and have announced an intention to move toward a vertical clearing solution (NYSE Euronext). While it may be difficult to move from a horizontal model to a vertical model, the stickiness gained from a vertical model can be an effective strategy to parry competitors’ initiatives.
Matching engine technology innovation has mixed success as a differentiator. While radically new technologies (and for that matter, old) can certainly shift the liquidity balance both positively and negatively, however increasingly and over time, exchange technology differentiation is only temporal – lasting until the laggard can catch up. For the innovative exchanges, technology has always been a differentiating feature, as differences are increasingly measured in microseconds, the differentiating gaps are more likely due to other extenuating non-technology factors including more complex market structures, greater rule sets and increased compliance.
Increasingly technology is being used to differentiate non-matching engine services from selling exchange technology to co-location, direct market data provisioning, high-speed routing, and the ability to offer third-party technology services.
Market structure and pricing in the age of open information has also become a challenging differentiator. The ability to easily access and assimilate pricing and market structure information, as well as the technology to enable exchanges to quickly implement successful strategies, has made it much more difficult for exchanges to create a differentiated market structure or pricing model.
While it seems that just a decade ago pricing and market structure went through a revolution with the advent of the maker-taker pricing model, today pricing and market structure change as a differentiating feature seems all but impossible. Maybe there is a structure crying out for implementation, but today pricing, and market structures strategies, if effective, can be copied virtually overnight.
One of the largest hurdles has historically been regulation. Regulation such as concentration rules or other barriers to preference national markets have hurt upstarts in days past. In many jurisdictions, however, these walls have crumbled as exchanges, no longer industry-owned utilities, are for-profit companies that regulators feel are less protection-deserving. Many exchanges traditionally have also had their own regulatory infrastructures which in the transition to public entities the exchanges were were reestablished at arm’s length to avoid conflicts of interest. This has further eroded exchanges’ regulatory barriers.
With all of these challenges it may seem dour for the exchanges. It is not. Price competition and technology advancement has increased transaction flow and created opportunities for trading strategies that were not feasible under less advanced technologies and at higher costs. Exchanges have globalized, and are increasingly coming to terms with what it means to be global, opening up opportunity in previously walled-off foreign markets and transitioning from the entrenched to the upstart themselves. The expanding economy is also increasing the amount of underwriting and public offerings which increases listings fees. In addition as competition continues to pressure transaction and market fees, exchanges will target corporations and develop ways to provide these organizations more and better service.
Besides equity product origination there is increasing global legislative and regulatory pressure to push banks to convert OTC products to centrally cleared and eventually exchange-traded. While this will not go unchallenged by banks and brokers, the pressure is certainly there and likely to benefit the larger exchanges and clearinghouses.
While the exchange business may not be as glamorous and lucrative as it once was, it is, like the Chinese proverb, a whole lot more interesting. The exchange business is finally changing at the pace of the markets. While exchanges a decade ago may have been known for being stodgy and staid, we have, are, and will see a very significant evolution over this coming decade of what we think of as an exchange.
While I am sure that there will always be a place in the market for a neutral execution facility, less and less revenue will be generated by the matching buyer and seller in commodity products. The interesting thing will be watching how these marketplaces mature, grow and differentiate their strategies across their community, geography, product, technology, pricing, clearing, market structure, and regulation to build the market of the future.
About Larry Tabb
Larry Tabb, one of the industry’s leading market structure analyst, is founder and CEO of TABB Group, the strategic advisory and research firm focused exclusively on capital markets. Prior to launching TABB in 2003, now with offices in New York, Boston and London, he established TowerGroup’s Securities & Investments business. Quoted extensively and in virtually all major financial industry and business news media, he continues to be a featured speaker at major industry and business conferences throughout the US, Europe, Asia and Canada.