Looking Beyond Listings
Rumor has it that animosity at the top is behind NYSE Euronext Inc.’s rejection of Nasdaq OMX Group’s enhanced takeover bid, though a potential antitrust review would provide a more understandable pretext for refusal. If and when things ever get that far, government overseers would be well advised to look beyond the potential concentration of listings and consider how such a deal might alter the trend toward dark, off-exchange trading. That is where the real threat to orderly markets resides.
In recent years, exchanges have evolved away from the high-profile trading floors that provided the “show” for the evening news, and into data processing firms. As my colleague Rhodri Preece pointed out in a separate post a couple of weeks ago, the exchanges have become scale businesses, trying to run as much trading volume run through their systems as possible in a perpetual bid for bits of pennies of profit per trade. This fact alone should dispel most fears that a merger of the two would lead to monopolistic pricing.
The evolution began when electronic communications networks (ECNs) like Archipelago and Instinet invested heavily in technology to beat Nasdaq, the NYSE, the American, and regional exchanges at their own game. They traded faster, with less interference from intermediaries, and did so cheaper than the traditional venues, thus attracting significant trading volume. The exchanges were forced to respond by investing heavily in technology — and later in the ECNs themselves — to meet the competition. They went public, in part, to raise public capital to help fund these investments.
An Existential Threat
But what seemed like a good idea at the time helped spawn what is now an existential threat. Demutualization both monetized the capital of member broker-dealers and, more importantly, severed the ties that had previously bound these former patrons to the exchanges.
Broker-dealers were just as capable of investing in technology — and in some cases, more willing to — as the exchanges were now free to compete more aggressively with their former partners. Through payments for order flow, electronic crossing networks and dark pools, the broker-dealers became more effective and efficient at siphoning trading volume away from the exchanges and into their own internal de-facto exchanges than ever imagined.
Unfortunately, part of the reason for their success is the rule book. Exchanges play by one set of rules — they can’t act like broker-dealers, for example — while broker-dealers — who can and do act as de facto exchanges by “internalizing” their customers’ orders in their back offices — operate under another. By the end of 2009, broker-dealer systems had grabbed 17.5 percent of total NMS trading volume for the year, according to the SEC’s Equity Markets Concept Release. By comparison, NYSE had 14.7 percent, and 27.9 percent when the exchange is combined with NYSE Arca.
As part of its Concept Release, the SEC proposed a trade-at rule (TAR) to remedy some of these imbalances. TAR would prevent internalizers, dark market participants, and even broker-dealers from stepping ahead of the National Best Bid or Offer (NBBO) at the last nanosecond with no or minimal price improvement — 1/100th of a penny is pretty minimal for most investors. If, and only if, these entities were displaying a quote at a price equal to the NBBO for an unspecified period of time would they be able to step in front of the NBBO. It is an idea that CFA Institute has endorsed, though the potential complexity of the rule, and the significant difficulties that implementation would bring to regulators, exchanges, and others, makes adoption anything but a certainty.
What is certain, however, is that the power brokers in the U.S.’s new financial center — Washington D.C. — will take a close and critical look at any combination of Nasdaq and NYS Euronext. If and when they do, they would be well advised to look beyond traditional antitrust measures before blocking such a combination.