Above the Law

What exchanges and kings have in common

It must be good to be a king. Sitting in your castle, taxing peasants and silencing opponents. Laughing it up with the court jesters and courtesans, while drinking quarts of whatever it is kings drink. (Scotch? Wine? Gravy?) But perhaps better than holding court would be the courts you avoid, because as king, you could never find yourself a defendant in a civil or criminal court.

Going back to 13th-century England, the Crown has been immune from lawsuits, in a common-law doctrine known as “sovereign immunity.” In America, sovereign immunity applies to the government and its entities. You can’t sue the post office for losing a package, and you can’t sue the USDA for labeling “pink slime” as meat. Recently, the ancient doctrine of sovereign immunity has become part of traders’ conversations, as broker-dealers learned that they can’t sue exchanges for errors, even really big ones, like botching the opening cross of a very large IPO.

Why would an exchange qualify for sovereign immunity? Aren’t they for-profit companies like Microsoft or Walmart? Yes, they are. For the past six years, the New York Stock Exchange and Nasdaq have been for-profit companies that exist to make money for their shareholders. Yet they have also been deemed by courts to be quasi-governmental entities, dating back to the 1934 Exchange Act, in which Congress delegated some regulatory responsibilities to the exchanges. But even after the exchanges “demutualized,” their quasi-governmental status was still upheld in courts. For example, in a September 2007 court decision (Calpers v. NYSE, Second Circuit), an appeals court dismissed a suit against the NYSE, finding the exchange “stands in the shoes of the SEC” and therefore even if misconduct had occurred, “absolute immunity” applies.

Absolute immunity is a pretty cool thing to have. It’s like being a legal superman. Bullets like “gross negligence” and “willful misconduct” just bounce off you. Imagine life if your actions had no consequences. You could spend your days dropping things from balconies and leaving banana peels on the sidewalk. Yes, life would be sweet, at least for you. For those around you, though, life may be a bit less sweet. Economists refer to situations with a lack of consequences for negative actions as creating “moral hazard.” Kids hopefully learn that if they send a baseball through the neighbor’s window, they’re going to have to pay for it. Tell the kid it’s not his problem, and you’ve created moral hazard, along with a lot of future broken windows.

To avoid broken windows where possible, society should be stingy about bestowing immunity on organizations. So why are exchanges treated like kings and granted sovereign immunity? Unlike in the past, today every exchange except BATS outsources all or most of its regulatory responsibilities to the Financial Industry Regulatory Authority. It is beyond a stretch to call Nasdaq or Arca a branch of government, even if they do still have some regulatory tasks. [Editor’s note: Mathisson was on the board of BATS from 2007 to 2010.]

Imagine if American Airlines were responsible for monitoring passenger compliance with Federal Aviation Administration rules. You could call these imagined regulatory personnel “flight attendants.” In making you shut off your cell phone before takeoff, the airline is standing in the shoes of the FAA. Therefore, using the same logic as is applied to the exchanges, American Airlines should be deemed a quasi-governmental entity and granted sovereign immunity in lawsuits.

Meanwhile, the exchanges look less like government regulators and more like broker-dealers every year. In May, Nasdaq announced it was going to compete directly with brokers by offering trading algorithms. In July, the NYSE had its “Retail Liquidity Program” approved. The headline the next day in the Wall Street Journal announced, “The NYSE Gets Its Very Own Dark Pool.” The reality is that the line between exchanges and ATSs (Alternative Trading Systems) is blurrier than ever. Both accept buy and sell orders and match them electronically. Both offer dark orders. Both offer displayed orders. Both typically offer a lower price to their top clients. The only real differences between exchanges and ATSs are in their legal status and their economics. Exchanges pay no clearing fees; ATSs do. Exchanges receive tape revenue on quotes and prints; ATSs don’t. Exchanges have no net capital requirements; ATSs do. And exchanges have no liability when they make an error; ATSs have to pay up when they mess up.

On the other hand, exchanges have a longer regulatory review process when they want to change their rules. Given their lack of liability and the moral hazard it creates, it probably makes sense for their changes to get a bit of extra scrutiny. But the largest exchanges have taken to banging the drum in Washington and demanding a “leveling of the playing field,” claiming that the additional regulatory burden economically disadvantages them relative to ATSs.

If the exchanges’ claim of unfairness is correct, then the management of BATS and Direct Edge must not be very smart. Because both companies were running successful ATSs, and both voluntarily chose to convert to being exchanges, finding the economics and the legal advantages to be overwhelmingly slanted in favor of exchanges. Meanwhile, broker-owned ATSs are denied the chance to become exchanges, held back by an obsolete restriction that a broker may only own a maximum of 20 percent of an exchange. This restriction may have made sense when exchanges were member-owned, not-for-profit entities that doubled as regulators, but it no longer makes sense in a world of for-profit exchanges that act like broker-dealers and outsource their regulatory functions.

Perhaps it is time for lawmakers to consider a true leveling of the playing field, by removing all of the arbitrary distinctions between exchanges and ATSs. I suggest the regulators create one set of rules for both, which would include common rules around tape revenue, rule approval procedures, net capital requirements, clearing fees and, of course, sovereign immunity.

In England, the Crown continues to gradually lose privileges. In 1992, the Queen agreed to start paying taxes. In 2011, she lost her theoretical right to dissolve Parliament. Maybe one day, the Queen will lose her sovereign immunity and we will see her get sued, perhaps because one of her palace guards wearing those fuzzy black hats will get heat stroke on a hot summer day. When that day comes, as the Queen sits in court waiting to testify, we may hear her murmur, “It must be good to be an exchange.”

Dan Mathisson is a columnist for Traders Magazine, and the Head of U.S. Equity Trading at Credit Suisse. The opinions expressed in this column are entirely his own, and do not necessarily represent the opinions of the Credit Suisse Group.