As a sign of the evolving U.S. equity trading landscape, two startups and one options exchange operator plan to launch as many as three new exchange platforms in 2020, and a fourth could be waiting in the wings.
Members Exchange (MEMX), Long Term Stock Exchange (LTSE), and Miami International Holdings, operator of the MIAX Exchange Group, plan to compete with incumbent stock exchange operators, according to speakers at the SIFMA Equity Market Structure Conference held Sept. 19 in New York City.
On Oct. 2nd, Reuters reported that Intelligent Cross, a dark pool based on artificial intelligence, plans either to become an exchange or partner with an exchange to distribute its quotes to the public to better compete with the likes of the New York Stock Exchange and Nasdaq. Now the startup wants to distribute bids and offers of its second order book, Adverse Selection Protection Engine or Aspen. “Our goal is to get our quote on the tape,” said Roman Ginis , CEO of Imperative Execution, who also spoke at SIFMA.
All of this is happening at a time when regulators and industry participants are calling for a review of Reg NMS and the Order Protection Rule, which were passed nearly 15 years ago when exchanges were not automated.
Emphasizing the need for competition and innovation in US equity market structure, new entrants have downplayed the increased connectivity costs and additional fragmentation of orders across trading venues.
Even a regulator suggested the stock market is not as competitive as it could be.
“Despite the growth in numbers of exchanges, 12 of the 13 active markets account for 60% of the ADV [average daily volume],” said SEC Commissioner Elad Roisman, in a keynote speech at SIFMA, who pointed to the consolidation of stock exchanges that has occurred through acquisitions.
“Competition is very good for the market,” said Jonathan Kellner, CEO of Members Exchange or MEMX, the startup owned by nine high-profile firms: Bank of America Merrill Lynch, Charles Schwab, Citadel Securities, E*TRADE, Fidelity Investments, Morgan Stanley, TD Ameritrade, UBS, and Virtu Financial.
But with 13 stock exchanges currently operating, that number could soon rise to 16 exchanges, causing some to question the value proposition to buy-side investors who already navigate a complex landscape. “Why do we need another?” asked Sapna Patel, Executive director, Head of Americas Market Structure and Liquidity Strategy at Morgan Stanley, who was asking the question on behalf of the buy side.
Citing the need for competition and innovation, Kellner said, that MEMX would push other exchanges to innovate and it would put pressure on fees. Also, he said it will give brokers a voice at the market structure debate as SROs [self- regulatory organizations] on issues like market data, which was the main catalyst in the formation of MEMX, he said. By forming their own exchange, broker dealers that own MEMX will gain a seat on the SIP Operating Committee which governs the securities information processor – or SIP – the consolidated market data feed.
As far as the cost of connecting to additional exchanges, based on conversations with broker dealers, Kellner maintained that the increased cost to connect is minimal. “The benefits outweigh the increased costs,” he asserted.
The drive to lower costs with new technology is also central to Miami International Holding’s (MIH) value proposition. “We’re going to start out 40% cheaper than the lowest cost operator today,” said Thomas Gallagher, chairman and CEO of MIH, which established MIAX Exchange Group.
MIAX’s three options exchanges — MIAX Options, MIAX Pearl and MIAX Emerald — are on track to trade 500 million contracts this year and have garnered between 10 and 11 percent market share in options trading.
“We will take that technology infrastructure and apply it to equities,” said Gallagher, who said he raised about $300 million to build the infrastructure from investors that are families in the Middle East, Latin America, and Europe who wanted the transparency of an equities exchange. As a differentiator, the new equities exchange will go after the Hispanic entrepreneur and plans to have region specific securities offerings.
Simplifying Order Types
While the new venues collectively are going to inject more platforms into the market structure, each one claims its goal is to simplify trading.
“Our game plan is to keep it simple, keep it cheap. Create incentives for the industry to participate,” said Gallagher, who said it was aligning owners with users, following a model like MEMX.
MIH partnered with Hudson Trading and CTC Trading Group to launch a cash equities exchange to supplement is options business under the MIAX Pearl license, reported The Trade in May. MIAX also received investments from existing exchange members IMC, Simplex Trading, Susquehanna Securities, and Two Sigma.
As it did with options, MIAX’s strategy has been to offer liquidity providers an equity stake if they maintain certain volume threshold’s over time. “We will offer six or seven liquidity partners the right to own about 3.5 % of the company over the next 36 months from the launch date if we deliver on what our promise is,” said Gallagher. He expects the equities exchange to launch in the Q2 or Q3 of next year.
Differentiate with Technology
For its part, MEMX also wants to simplify the order types, noting that its member owners are familiar with all the order types that exist.
“The differentiator here is we have a greenfield opportunity to build an exchange from scratch,” said Kellner. “Technology has really improved over the last few years. We’re not looking to innovate via the market structure. We’re looking to innovate via technology,” said Kellner.
Likewise, Long Term Stock Exchange CEO Zoran Perkov said the LTSE will offer a “simple market model” with simple order types. “Our simple market model is a trading platform; it carries a subset of what you find in the broader market where you only have the ability to display an order,” said Perkov, a serial builder of SROs who previously worked at Nasdaq and IEX.
While other new entrants are aligned with broker dealers or market makers, LTSE is the first U.S. national securities exchange primarily designed to support corporate issuers and investors “who measure success in years and decades, not financial quarters,” stated LTSE in a Sept. 18 announcement.
In that release, LTSE said it intends to file a rule proposal with the SEC to change the rules, so that all buying and selling of shares will occur exclusively at prices displayed to all participants.
On LTSE, there won’t be any hidden or reserve liquidity on that market. “There will be simple order types on that market. We feel that is consistent with the idea of what an exchange is — one allowing companies to raise capital and allowing investors to express their interest,” he said.
Incumbents Weigh New Venues
Meanwhile, incumbent exchanges such as Nasdaq, which own additional exchange licenses, could have the option to light up another venue at any time. “We have six medallions and three are idle, said Tal Cohen, Executive Vice President and Head of North American Market Services at Nasdaq on the SIFMA panel.
“Nasdaq looks to solve problems in the market,” said Cohen, stressing that the exchange operator grapples with the decision of how to deploy its exchange licenses.
“We are trying to be responsible. We’re trying to understand the segments of the market that require competition,” said Cohen.
For example, “if there are illiquid names that trade 5,000, 10,000, or 15,000 shares a day, Nasdaq would weigh, do we need a 15th or 16th exchange?” explained Cohen. He said that Nasdaq has been thoughtful in not lighting up another venue, pointing to the decision to offer the Midpoint Extended Life Order or M-ELO, as a non-displayed order type. “We made a conscious decision of innovating on an existing platform vs. launching a fourth medallion,” said Cohen.
With the focus of exchanges on price and speed, some argue that it has been difficult for public exchanges to innovate under Reg NMS.
“The current regulatory environment certainly dictates how innovative you can be in this space. And price-time in a Reg NMS world, and especially the Order Protection Rule, constrains you to a certain degree,” said Patel of Morgan Stanley.
Some have blamed the Order Protection Rule (OPR) for the proliferation of small exchanges since the rule requires brokers to route investor orders to protected quotes that are immediately accessible.
Calls to Reassess Order Protection Rule
In his keynote speech at SIFMA’s conference, SEC Commissioner Roisman suggested the Commission ought to look more closely at providing more guidance on best execution and to reassess the Order Protection Rule known as OPR which has allowed exchanges to get “protected quote status” under Regulation NMS.
OPR, or Rule 611, also known as the trade-through rule, “establishes intermarket protection against trade-throughs for all NMS stocks,” according to Reg NMS. It “requires trading centers to enforce written policies and procedures to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers, subject to an applicable exception. To be protected, a quotation must be immediately and automatically accessible.”
Trading centers are broadly defined to include all types of venues including registered exchanges, ATSs, off-exchange market makers, and any other broker-dealers that execute trades internally as principal or agent.
However, OPR has been criticized for causing lit venues to compete based on speed and maker-taker fees, rather than stability and liquidity.
Roisman suggested that brokers are ignoring other factors pertaining to best execution, such as size, trading characteristics, transaction costs and ease of fill. “My concern is that emphasis on price and time and the avoidance of trade-throughs has become a substitute for a more robust best execution analysis,” said Roisman adding that brokers may be focusing on these two factors to avoid criticism from regulators and customers.
Roisman also noted that OPR has “forced brokers to connect to, purchase market data from, and take into account prices on all exchanges.” To lower the cost of connecting to many smaller exchanges, some suggest there should be a volume threshold to qualify for a de minimis exception from OPR applying to small exchanges.
“If we’re going to try to address concern about fragmentation and the cost of interacting and the technology to interact with ‘N‘ number of markets, then it’s natural that OPR is going to become part of that discussion,” said Michael Blaugrund, Head of Equities at NYSE, which operates five venues.
“Should OPR apply only to exchanges that reach a specific minimum ADV over a set period -of time?” asked the SEC Commissioner.
Proposed Exceptions to OPR
Various proposals are pending before the SEC to create a de minimis exception to OPR for old and new small exchanges. Nasdaq has proposed a threshold of at least 1.5 % of the volume, while NYSE proposed 1% before venues would qualify for protection. Other ideas are to utilize OPR only for listed markets or to create a display threshold, said Blaugrund.
However, any volume threshold for OPR could raise the barriers to entry for new entrants that meet the requirements of an exchange.
MIH’s Gallagher said it would be unjust for the SEC to change the rule now since that would hurt new exchanges from building up their volumes. It takes several years to offer the innovations and get SEC approval, he noted.
“If until you get to a certain market share or displayed volume threshold you can’t have any assistance, I don’t think that’s fair,” said Gallagher. If there is a new rule, then the SEC should give new entrants a period-of-time to get traction, he said.
Amidst all the talk of reviewing or eliminating the OPR, panelists suggested there should be more discussion with the industry before reaching any conclusions, while the SEC Commissioner and new entrants warned of unintended consequences. Wearing his engineering hat, Perkov suggested it could take years to remove the OPR code from everyone’s systems. In the meantime, the exchange landscape will continue to evolve.