The Oligopoly of Exchanges & The Blockchain Solution

Singapore, SINGAPORE – Andrei Vishenko (obviously not his real name) chomps down on a hundred-dollar Cuban, fiddling with his thousand-dollar duPont cigar lighter. Seated in the plush leather sofa in the smoking lounge of one of Moscow’s most exclusive restaurants, the White Rabbit, Vishenko waxes lyrical about the hypocrisy of democracy,

“You Americans (yes, they really do speak that way), you’re always going on about your ‘democracy’ and how your system is better than what we have in Russia.”

“At least here in Russia, we embrace our oligarchs. But you? You and your lobbyists and your hidden agendas. It is enough to make one sick to the stomach.”

But before I can protest further about Vishenko’s unsubstantiated and patently wrong assertions about this great country this of thee, sweet land of liberty, a waiter interrupts my protests with perhaps what is the finest serving of Petrossian caviar and blinis (a sort of mini Russian pancake, like if iHop’s pancakes were Matryoshka dolls, this would be the last one) and some Russian Standard vodka.

The White Rabbit restaurant in Moscow — because that’s how you oligarch.

But eager to defend this great nation, I struggle with the question, are there oligopolies in this bastion of capitalism and freedom of enterprise.

As much as I would hate to admit it, Vishenko is right and nowhere is this more obvious than in the stock market.

It’s easy to take it for granted that the New York Stock Exchange (NYSE) is the epicenter of global trade in the stock of some of the world’s most prestigious and envied companies.

Macy’s Thanksgiving Day Parade took on a decidedly more corporate look

But what is easy to forget is that it wasn’t always this way. There wasn’t always one stock market.

For over a century, stock exchanges, because of their natural economies of scale, were like railroads and utilities, not-for-profit, self-regulated entities, owned and operated by their broker-members.

But after copious deregulation under the Reagan administration, most stock exchanges became for-profit companies, oftentimes listed on their very own exchanges.

The NYSE for instance was listed on its own exchange in 2006, around the same time the Securities and Exchange Commission (SEC) created the National Market System (NMS) — rules that were designed to foster competition between the different exchanges.

One of the most important rules in the NMS is Rule 611, the “order-protection rule”which requires brokers to route trades to the exchange that displays the best price.

Coupled with advances in technology, in particular the gradual decline of the open outcry trading floor in favor of digital orders, new stock market competitors threw their hat in the ring and created what on the surface appears to be a fragmented market.

In the United States alone there are no less than 13 stock exchanges and 44 off-exchange centers, sometimes referred to as dark pools — but are a lot less sinister than they sound. Dark pools are run by banks and other trading houses to match-make large orders privately.

But the market is far less competitive than it appears. Nasdaq and the Intercontinental Exchange (ICE) have been on a global acquisition binge, gobbling up European competitors.

The set of Star Trek looked a lot less impressive after production budget cuts set in.

Combined, ICE, Nasdaq and the Chicago Board of Exchange (CBoE) account for over 95% of all trades done in the United States, with almost all but one exchange owned by these three players.

And even among all the stock exchanges that exist in the United States, there is still very little competition. Two of the five exchanges owned by NYSE have less than 1% of all trading and another pair, less than 3%.

But because Rule 611 requires brokers to route trades to exchanges which provide the best price, brokers are forced to track prices on every exchange, a service which the exchanges charge for dearly.

Brokers must pay, among a growing list of charges, connection fees for each and every exchange.

But that’s not the only way that the exchange oligopolists milk the system. As any trader will tell you, speed of information matters.

The slow and shaky price information received by the public is free, but for brokers looking for that nanosecond advantage in their trading algorithms, exchanges provide a high quality, near instant data feed, at an exorbitant price.

And brokers looking for speed in execution? That costs extra as well, with exchanges charging brokers rental fees for computers located within the exchange, allowing them to shave nanoseconds (well milliseconds at least) in trade execution time — often times the difference between a profit or a loss in high frequency trading strategies.

A New Tide for Exchanges

Thanks to deregulation, stock exchanges today have considerable control over the capital markets and wield significant power over market participants, leading one group of American brokers and banks to attempt to create their own exchange.

On January 7 this year, nine of America’s largest brokers and banks announced that they were planning to launch a new stock exchange known as the Members Exchange (MEMX).

But MEMX is hardly the first nor is it likely to be the last attempt to break the oligopolist exchange companies’ stranglehold on the capital markets.

In 2016, IEX, an independent stock exchange launched amidst much fanfare, vowing to put an end to information asymmetry and to be “built for fairness,” even going so far as to thwart high frequency traders by using a “speed bump” — a coil of fiber optic cable that slows access to the market by 350 microseconds — an eternity for high frequency trading strategies.

Despite its egalitarian goals however, IEX has a market share in the United States well below 3%. But the advent of MEMX and IEX could come at a perfect time to utilize the blockchain to return parity and fairness to equity markets.

But if history is anything to go by, even if MEMX and IEX are successful in increasing their market share, there is sufficient evidence to believe that the oligopolists will move in to ensure their supremacy.

Over a decade ago, Direct Edge and BATS, two low-cost exchanges created by industry heavyweights looking to build better exchanges merged in 2014 and were subsequently bought out by CBoE after their rapid increase in market share became alarming for the incumbents.

Blockchain to the rescue?

As any purveyor of fine cryptocurrencies will tell you, cryptocurrency exchanges were built with (profits) decentralization in mind (for the most part).

Stock markets necessarily lend themselves towards the concentration of power and the centralization of trading.

It makes sense for brokers to invest in the markets with the greatest liquidity.

It makes sense for traders to trade in the markets with the fastest order execution.

And as profit-driven corporations, it makes sense for stock exchanges to bilk stakeholders for all they’re worth, one way or another.

Which is where decentralized exchanges come in and where perhaps the stock market or any endeavor to build a better stock market may perhaps take a leaf out of the cryptocurrency playbook.

For one, order execution is almost instantaneous on the blockchain. Whereas a typical stock market trade may be instantaneous on the screen, behind the scenes, score of Oompa Loompas execute and complete these trades and can take anywhere from 3 days to 7 days for settlement.

In the meantime, the funds of traders are stuck in limbo. The usefulness of blockchain technology has already been recognized early on by Nasdaq, who as far back as 2015, before the heady days of initial coin offerings (or as some refer to it as “The Before Times”), were already experimenting with blockchain technology for trade clearance.

As recently as late 2018, the Singapore Exchange and Singapore’s central bank, the Monetary Authority of Singapore also experimented with using blockchain technology for trading and settlement of tokenized assets.

The potential for blockchain technology to improve current trading structures is tremendous.

Not only could settlement be faster, decentralized trading of assets presents a natural barrier to the (at times) unfair advantage afforded by high frequency trading strategies (HFTs).

To be sure, the overuse and prevalence of HFTs over the last decade has whittled down trading advantages to nanoseconds. HFTs have also been blamed for many of the flash crashes which the markets have periodically experienced over the last decade as well, a phenomenon that is only likely to increase in regularity and magnitude.

But because blockchain transactions need to be propagated throughout the network, such trading is naturally slower than in the current trading systems.

It’s also more internationally accessible. Suddenly the few blocks of real estate around Wall Street aren’t so crucial anymore. The extra nanoseconds of fiber advantage aren’t as relevant.

Already in centralized cryptocurrency exchanges such as Binance, there are in-built rate limits, which prevent HFTs — a crucial factor for adoption because it allows more grassroots traders to throw their hats in the ring. And it also allows a trader sitting in his parent’s basement to have as good a chance at trading success as the Wall Street type sitting in an office in lower Manhattan.

Concentration in the stock markets is something that has been observed for some time now, with over three quarters of the stock market being held by institutional investors such as pension funds.

BlackRock, Vanguard and State Street together own over 40% of all publicly listed firms in the United States. Such concentration of trading power and assets in a few large asset managers presents not only systemic risk to the entire financial system, it reduces the ability of market forces for price discovery.

The concept of a perfectly competitive market (as postulated by economists) is that true price discovery can occur when there are a large number of small players.

But the nature of the U.S. stock market is such that the outsize influence of a few large, key players, can have altogether unforeseen consequences in the market — like a whale jumping into a swimming pool — no one can avoid the splash zone.

“Excuse me, sorry, coming through.”

Again, decentralized exchanges, of the sort conceptualized by 0x, a blockchain company building the technology to enable and empower decentralized exchanges may provide a natural solution.

By facilitating peer-to-peer or P2P transactions, markets have a better opportunity at price discovery, with the potential for price manipulation greatly reduced.

Even in supposedly transparent stock markets such as the NYSE, the SEC regularly discovers price-fixing, anti-competitive collusion and market machinations that pervert the functioning of the free market.

To be certain, there are existing P2P market places facilitated by Nasdaq, such as the over-the-counter or OTC markets. There are also secondary markets where yet to be listed shares can be traded, such as Nasdaq Private Market.

But these markets if nothing else facilitate even more “insider” deals dominated by an exclusive elite, with access both to the underlying shares as well as to the opportunities to purchase them.

But secondary markets do serve a purpose. They offer a way for startups to keep shareholding employees happy, especially those who are paper-rich but cash-poor.

And there’s no shortage of buyers in the secondary markets, almost all of whom are institutional-grade investors such as mutual funds, sovereign wealth funds, family offices and high net worth individuals.

Again, the cryptocurrency markets may provide an opportunity to improve on this otherwise exclusive model. Security tokens, or asset-backed tokens may be divisible to small enough units to allow even smallholders to trade such secondary market shares.

And it’s not just pre-IPO shares. The potential to tokenize literally any asset, means that entire asset classes which were up till now inaccessible to retail investors, may suddenly become accessible.

For instance, bonds and other derivatives which only exist in large ticket sizes, could be sufficiently tokenized to allow even the smallest of investors to gain access to a diversified portfolio.

And because a decentralized market theoretically allows almost anyone to create a contract for almost any tokenized asset, there is no limit to the extent to which financial innovation could be fostered.

The incorporation of blockchain technology however is likely to occur from the top down. As exchange owners such as ICE and Nasdaq experiment with blockchain technology, they will no doubt find ways to improve their processes, increase their efficiency and entrench their dominance.

The result of which will not necessarily diversify or increase the number of stock market participants, but continue to serve the interests of its existing stakeholders.

Given the current political climate in the United States, it is highly unlikely that there is any appetite to break up the stock market oligopolists.

Perhaps my friend Vishenko had a point when he said,

“An oligopolist in the West is simply known as a successful entrepreneur.”

“Whether the caviar comes from Crimea or China, you still eat it.”

The writer is Patrick Tan, Partner and General Counsel for cryptocurrency quant trading firm Compton Hughes.