As the sun rises on 2019, it will also be shining on a new equities exchange application. The launch of Members Exchange (MEMX), founded by a consortium of nine financial services firms, was announced this week, and according to the press release, it will apply for U.S. Securities and Exchange Commission (SEC) approval in early 2019. Given the IEX exchange application approval and the public fights between the incumbent exchanges and their members, the introduction of a new exchange application should be no surprise. There are already 13 exchanges and over 45 equity alternative trading systems (ATSs) operating in the U.S.; MEMX will make number 14.
Over the past 20 years, we’ve been through two major arcs of modern market fragmentation and consolidation in the U.S. exchange industry. Demutualization kicked it off by thrusting exchanges at odds with their members. The first round was fought in the late 1990s and early 2000s, and pitted electronic communication networks like Island against the incumbent exchanges. Then, in the mid- to late-2000s, BATS and Direct Edge gained significant market share by offering market models that catered to the next generation of market-makers—high-frequency trading firms. Each time a new entrant was successful, it was in part because its interests were in line with its members and because it had members represented in its cap table. The market has consolidated itself down to three major exchange groups, with one independent exchange and a load of ATSs and dark pools, all competing for market share.
Faced with declining trading revenue and increased competition, exchanges have turned to price-gouging the costs of data and technology. So their customers have become price-conscious and vocal. The SEC has often found itself forced to referee lawsuits and administrative proceedings brought by firms filing suit against exchanges over unfair and unreasonable charges. And while it seems like the issues with access fees are mostly behind the industry and the upcoming access fee pilot will end them, the most recent debate is more focused on market data and technology fees. The SEC has been taking a stance against the exchanges too; recently it requested transparency on the fees they charge and rejected requests by the exchanges to raise market data fees. The nuances and complexities of the fee schedules can get complicated, despite Virtu chief executive officer Doug Cifu’s best efforts to dumb it down through a show-and-tell of networking equipment and an explanation of their cost during SEC-hosted industry roundtables.
It may look like a rinse-and-repeat exercise when a consortium of banks, brokerages, and high-frequency trading firms band together to launch a new U.S. exchange such as MEMX. But the market’s structure is different than it was the last two times. With round one, the government was intervening to break up a monopolistic market structure that lacked technological innovation. The marketplace had a kaleidoscope of participants providing supply of and demand for order flow. During the second round, during a period of rising markets and volume, dozens of new and sophisticated liquidity providers were looking for a platform to trade since the incumbent exchanges couldn’t keep up. The contour of participants has continued to change since then, particularly since the 2008 global financial crisis and its consequences on the capital markets. Fewer banks remain, and the ones left have almost all exited primary market-making businesses. The high-frequency trading industry has changed too; profits have normalized, and only a fraction of firms with the speed and scale to survive remain. Now we seem to have a market structure with a small homogeneous pool of similar-looking participants.
Will it work? Even though MEMX’s website and press release don’t offer many details, we can be sure its primary value proposition will be a lower cost and a simpler model than what is currently offered. But will that be enough, or must it offer a market model that is new and differentiated?
MEMX has a good chance of winning market share from the incumbent exchange groups. This new exchange—consortium-owned by nine firms—is largely being led by Virtu and Citadel, which together control about 40% of order flow in U.S. markets. He who controls the market’s liquidity controls the market. With the members as owners of MEMX, the exchange should be able to build the market and fee structures in their image. On the surface, it seems like the owners are in good positions: Start a new exchange, route your order flow to it; maybe you exit, and maybe you don’t. Still, MEMX might just be a bluff by its owners to try and force the exchanges’ hand and come to terms with reduced pricing—a metric that would allow the members to declare victory.
However, we’ve seen other consortium-owned exchanges and venues try to enter and fail. While it’s not expensive to build exchange technology any longer, it is risky to run an exchange, and it can get costly to manage over the long term. Large competitive financial institutions almost always find it challenging to collaborate. And the exchanges have gotten much savvier than they were when they found their market shares picked off by Direct Edge and BATS. I suspect that the exchanges are much tougher this time and are better prepared to defend their positions.
Cost pressures are being felt all around, but some firms in the supply chain refuse to budge. This is not the first attempt by the banks and brokers to lean on the supply chain around them. We’ve seen the large consortium play with banks firing shots across the bows of incumbent providers before. BIDS, LeveL, and Luminex are examples of consortium-backed ATSs. It's interesting, and telling, that the influential banks like Goldman Sachs, Credit Suisse, and Citi are missing from the MEMX consortium. Another example that comes to mind is Symphony, also consortium-owned, versus Bloomberg.
Does the market need another equities exchange? Probably not. But more importantly, what will another exchange mean for the quality of the quote? Should we expect another proposal that fragments the closing auction? And are we ignoring how the maturity of private equity and venture capital has changed the utility of the public markets? Meanwhile, chief financial officer decisions to buy back stock and avoid stock splits mean higher share prices, less volatility, less traded volume, and a smaller commissions wallet. Is the industry missing the bigger picture?
MEMX is probably not the only group thinking about launching a new competitive and member-owned exchange. Virtu is continuing to aggressively expand its reach. Pay attention to what Virtu does with Posit considering the MEMX announcement. And don’t count out the other ATSs that have entered the market with their innovations over the past few years, such as CODA Markets and Imperative Execution.
While I believe MEMX is bringing the fight to the exchanges because of the data and technology fees it charges, the upcoming access fee pilot is bound to shake up market shares among the exchanges and ATSs, and it may pose another reason for MEMX to win out. In a post-pilot world in which exchanges can’t rebate customers for posting liquidity, it probably makes more sense for market-makers to insource (or own) the exchange function. And as long as pesky NMS Rule 611 remains in place, market-makers will prefer to own the exchange in order to make sure their quotes are protected at a reasonable cost.
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