While traditional stock exchange business models can pull revenue from diverse sources depending on the exchange, companies listing on the exchange are often considered the primary client. One disruption playing out in the United States concerns exchanges taking a deeper focus on the needs of institutional investors.
The Investors Exchange, or IEX, was formed by Brad Katsuyama, who sought to open a window into the alleged complexity of order types and opaque system of rebates that make up the plumbing that underlies the US market structure. IEX states that ‘every investor has the right to trade on equal and fair terms, on every trade’.
There has been ongoing debate on whether the emphasis on speed of routing and rebates is allowing some to profit at the expense of longer-term investors. Some question whether exchanges are overly focused on catering to high frequency trading (HFT) firms. In practice, high frequency traders are able to buy and sell stock microseconds ahead of other investors, skimming fractions of a penny off each trade. Critics of this practice argue that profits generated from this practice come at the expense of other investors in the market, particularly retail investors.
There have also been complaints against HFT firms for conducting predatory strategies and studies have attributed their trading to causing and exacerbating flash crashes. Some studies have also shown that HFT is positively correlated with stock price volatility; however, other studies have found the evidence to be inconclusive. Proponents of HFT say it has increased liquidity, narrowed the bid offer spreads for investors and generally made the market more efficient for investors. While existing US exchanges and high-frequency trading firms fought IEX’s application to become an exchange, arguing that IEX’s speed bump violated the rule that quotes must be immediately accessible, in 2016 IEX won approval from the US Securities and Exchange Commission (SEC) to officially launch as a US stock exchange.
IEX was created as a dark pool, which is a private venue that can match large orders away from the public markets. To finance the venue, IEX raised money from investment firms who have expressed concerns about investor fairness in financial markets.
IEX built its model largely around the idea of a speed bump to slow down HFT firms, who were jumping ahead of customer orders. The so-called ‘magic shoebox’ consisted of 38 miles of coiled cable, creating a 350-microsecond delay to prevent high-speed traders that had faster data feeds from executing resting orders on IEX’s matching engine at a stale quote. In addition, IEX invented D-Peg, a new order type to protect investor orders while the quote is changing. The idea is that investors avoid paying (or selling at) a worse price to a predatory strategy that is aware of quote changes ahead of them. IEX also does not offer or sell colocation services to trader and brokers, which allows them to put their servers closer to the matching engine.
In June 2018, an economist at the SEC published a research paper showing that since IEX’s launch as an exchange, market quality, as measured by quoted, effective and realized spreads, actually improved for stocks trading on IEX.
Another difference in its model is that IEX is not paying rebates to brokers. The industry practice dubbed ‘makertaker’ involves exchanges paying brokers and dealers up to 28 cents per 100 shares for placing bids and offers, and then charging other brokers and dealers up to 30 cents for accessing those bids and offers. The difference between the make or taker fee is what the exchanges keep as profit. Opponents of exchanges paying rebates argue that it creates a conflict of interest for brokers, while proponents contend that it is an important tool to maintain the liquidity of equity markets.
In March 2018, the SEC announced plans to launch a pilot programme to test the effects of lowering stock exchange fees, following criticism that the current pricing system ultimately hurts investors. Nasdaq, the New York Stock Exchange (NYSE) and Cboe all came out publicly against this pilot programme, citing increased costs for investors and companies as well as questioning the legality of the pilot itself. However, a number of major pension plans and asset managers, including California Public Employees’ Retirement System, Ontario Teachers’ Pension Plan, BlackRock and Vanguard, have all come out in support of the SEC’s pilot test. While IEX has also been vocal in its support of the pilot programme, in 2018 IEX proposed a new ‘Enhanced Market Maker’ program, that would give a one cent per 100 share discount when meeting certain requirements, including disqualifying the use of client order flow from earning the discount. IEX has confirmed its view that this is not a rebate, but rather a discount that would help align the incentives of key stakeholders, investors, companies, brokers and market makers. It should be noted that the PRI has also publicly supported the pilot.
Illustrating a potentially growing trend, in 2017 the NYSE announced that its NYSE American market would implement a speed-bump on incoming and outgoing orders and on proprietary market data. The NYSE, which is owned by the Intercontinental Exchange, said that NYSE American will have the same type of speed bump with a 350-microsecond delay, except that it will have electronic market makers to ease the trading of NYSE-American listed stocks. In contrast to IEX’s position on rebates, then NYSE COO Stacey Cunningham, now CEO, made the case that rebates are critical for reducing the cost of capital and share price volatility for its issuers. The rebates NYSE is paying to market makers on its NYSE American exchange are among the highest in the industry, which could pose a challenge for IEX. NYSE has said that it launched the delay to give investors choice, while IEX stated that the Investors Exchange was meant to level the playing field for investors. It remains to be seen how much market share IEX or NYSE America will attract. In July 2018, IEX had an average market share of 2.435%. While the debate around the impact HFT and use of rebates has on the market continues, two new exchanges have opened in the US to meet what they deem as a market need.
Long-term stock exchange
IEX and NYSE are not the only stock exchanges to experiment with a new business model to address the needs of long-term investors.
In Silicon Valley, Eric Reiss, an entrepreneur and author of The Lean Startup, is working on a proposal to apply to the SEC for approval to operationalize a new concept for a stock exchange. His start-up, which is backed by investors and venture capitalists, is working on the concept of creating a stock exchange with governance rules to reward long-term shareholding and help public companies make decisions that promote long-term value creation.
The aptly named Long Term Stock Exchange (LTSE) is looking at overhauling the process used by US technology firms to list their shares and reduce the pressures that public companies face from high frequency trading, cynical activists and the short-term incentives of quarterly earnings results. Reiss’s view is that high frequency trading, short selling and quarterly investor pressures dominate share trading and hinder the growth of the underlying businesses whose shares are traded on exchanges.
There is strong evidence that short-term thinking has stymied innovation and had a negative impact on corporate growth. Companies that operate with a long-term outlook have consistently outperformed their industry peers since 2001 across almost every financial measure including revenue, earnings and job creation. However, research shows that companies will forego efforts to create longterm value because of pressure to meet short-term objectives. Studies have also pointed to a roughly 50% decline in the number of public companies from 1996 to 2016, a triple digit increase in CEO compensation from 1978 to 2014 coupled with pay totals that were poorly aligned with total shareholder return performance, and an increased emphasis on ESG issues among both activist and institutional investors. In order to reorient companies and investors around long-term thinking, the LTSE plans to reinvent the public company experience with different approaches to executive compensation, shareholder voting, disclosure practices, board and stakeholder policies, and community governance.
Among the key differences of the LTSE from traditional exchanges are: 1) Shareholder voting power based on tenure, meaning that a shareholder’s vote would be proportionally weighted by the length of time the shares have been held. 2) Listed companies would agree to mandated ties between executive pay and long-term business performance. 3) Disclosure requirements that help companies to better understand their long-term shareholders and assist these shareholders in knowing what investments the company is making.
The LTSE has suggested that playing a proactive role in creating long-term markets is one way that exchanges can attract listings and increase financial performance. By creating a new stock exchange that allows companies to focus more on their customers than quarterly revenues, the LTSE believes it can address pressures that have kept companies from going public. However, building a new exchange from scratch involves the challenge of attracting investor activity to provide liquidity and fair prices. The LTSE has put forward a new concept for exchanges, investors, companies and regulators to consider: by playing a more proactive role in creating long-term markets and exchanges, and by leveraging their role as intermediary between companies and investors, they have a valuable opportunity to reshape their thinking.