Jeff Sprecher, the CEO of Interncontinental Exchange (ICE), made a number of interesting remarks this morning on his conference call that followed the release of the company's third-quarter earnings.
Jeff noted that the ICE/NYSE merger will likely close in a matter of days, but more important were his remarks on the state of the market.
It started off innocuously enough. An analyst asked Jeff if he felt that he was responsible for being a champion of the New York Stock Exchange, now that he was about to become CEO of the combined companies.
He started out by noting that current NYSE CEO Duncan Niederauer would remain on the team for the next year (very good news), but then took a bit of a left turn.
He began talking about market structure. And he made it clear he is not happy with what he sees. Here's what he said:
"... a lot of the market model of what you are talking about is a market model that takes advantage of the fact that those people [retail traders] on that day have to sell. And that means that they can be charged usury rates and that means that they can have poorer information than people that they trade against when they put a market order in. And in the infrastructure of trading today is intermediaries who people are turning to and exchanges that people are turning to hoping that they will have a duty of care, but in reality those people are incented to take advantage of the people that are the weakest on the day they have to the trade.
And I think that that is fundamentally wrong. I think people that have built a business around that are destined to ultimately fail. I don't think they are sustainable. And increasingly when I go talk to friends and when I listen to people that are not involved specifically in what we do, there is a sense that things aren't fair,and that is the collective wisdom increasingly of the market. We're starting to finally see people ultimately talk about market structure changes and fundamentally revisiting why it is that we have equity exchanges. And I think we have equity exchanges so that companies like ICE that can start from nothing can attach to the capital markets to raise capital to build businesses, create jobs and be innovative and helpful to society.
I think the secondary market that takes advantage of people that have to trade or have poorer information is not particularly warranted or helpful or sustainable. And so, I'm anxious to be involved in the U.S. cash equities business from the sense that I think the New York Stock Exchange is incredibly well-positioned. I think the market model is going to change, I think people in the business want it to change, and hopefully by being transparent about it, we will be a positive force in causing it to change."
These are interesting—indeed, laudable—comments, but there's a problem here. Much of the business model of the NYSE is built around catering to high-frequency traders, from colocation facilities to proprietary data feeds. Many institutional traders—which are trading on behalf of retail clients—do not want to send order flow to the NYSE floor precisely because they are afraid of being picked off by these high frequency traders.
A second problem is how exchanges make money. All of them use a maker/taker model, where exchanges pay traders to provide liquidity, and charge them to take it. This means it can cost money to trade at the NYSE. They can trade cheaper in alternative facilities, like dark pools.
So, the business model depends on having large numbers of high frequency traders, and on the maker/taker model. What would happen if the NYSE (or any other exchange) abandoned the maker/taker model?
There's a very good chance that high-frequency traders would go elsewhere to trade where they can get paid.
Would the NYSE be willing to lose market share to gain back retail investor flow? How much would they be willing to lose? Could they make it up by attracting new order flow from retail clients?
Possibly, but as everyone knows, most retail order flow is already locked up. The order flow from almost all discount brokerage firms like ETrade or Scottrade or Charles Schwab is sold to a small group of firms (Knight, Citadel, UBS) who "internalize" the trades by matching off orders to buy and sell from their own internal order flow. Only rarely do any of these orders make it to the NYSE floor.
And what if you put an order through your broker to buy or sell a stock or a mutual fund? Chances are your broker will first route it to a dark pool, for the same reasons cited above.
Regardless, we need someone to at least speak up and ask these kinds of questions. There may be better ways to do things.
Let's hope Mr. Sprecher has started a dialogue others will pick up.
Speaking of market share, the NYSE's share of overall volume is continuing to slip. According to Sandler O'Neill, the NYSE accounted for 21.7 of total stock market volume in October, several percentage points below that of just a couple years ago.
Exchange share of volume during October:
- NYSE: 21.7%
- BATS: 10.2%
- Direct Edge: 10.3%
- NASDAQ: 19.2%
- Other (dark pools, internalizers): 37.3%
Now look at the numbers from December 2011:
- NYSE: 25.5%
- BATS: 11.2%
- Direct Edge: 9.7%
- NASDAQ: 20.7%
- Other (dark pools, internalizers): 32.0%
There are three important trends to note. First, NYSE share of total volume has slipped from 25.5 percent to 21.7 percent in just under two years. Second, dark pools are continuing to gain market share, now 37.3 percent of volume, from 32 percent. Third, the combined volume share of Direct Edge and BATS, the two small exchanges that compete against the NYSE and NASDAQ, is now 20.5 percent, almost equal to the volume share of the NYSE. This is important because Direct Edge and BATS have announced that they are merging in a deal that will likely close in the first half of 2014.
Bottom line: There is a new competitor in town.