It gets no respect.
Call it the Rodney Dangerfield of stock exchanges – the Chicago Stock Exchange. Oft forgotten amid the happenings of its Goliath big brothers, NYSE Euronext, NASDAQ OMX and BATS/Direct Edge, the nation’s only remaining independent stock exchange, also known as CHX, is reinventing itself. Real change is underway in the Second City.
The people who run the exchange know it has a bit of an image problem – recent data from Credit Suisse pointed out that the bourse handles just 0.5 percent of all U.S. trading volume. That compares to NYSE Euronext, Nasdaq OMX and BATS, each of which operates multiple exchanges ? 10 sub-exchanges in total ? and control the lion’s share of U.S. public trading volume.
NYSE and its smaller offshoots account for 23.1 percent of volume, NASDAQ 19.7 percent and BATS 20 percent. All told, these exchanges or lit venues control 62.8 percent of all U.S. equity trading volume.
Trades reported to the TRF account for 36.7 percent of volume.
“The Chicago Stock Exchange still exists?” asked one Chicago-based buysider when Traders called to solicit comment. “I thought they had quietly closed up.”
Now that’s an image problem for an exchange that traces its roots back to March 21, 1882, when the first formal meeting of brokers organized the bourse and elected Charles Henrotin as its first chairman and president. That’s after Mrs. O’Leary’s cow kicked a lantern in 1871 and caused the Great Fire, and before the world’s first skyscraper was built in 1885.
Back in its heyday in 1988, CHX had 10 percent of the market and 1,000 employees. Now it has about 80 staffers.
So what is going on in the Windy City?
Aware of its perception locally and nationally, the Chicago Stock Exchange brought in a new chief executive, John Kerin, to help refocus and guide the bourse in today’s advanced market structure. It has also made changes to its board of directors. In an interview with Traders, Kerin said the exchange knows it cannot compete head-to-head with NYSE/ICE, NASDAQ OMX or BATS/Direct Edge – rather, its goal is to be relevant in the21st century and grow its business.
Kerin told Traders that CHX is trying to make a name for itself regionally, in both the Chicagoland area or in New Jersey (where it’s collocated) and serve underserved niche markets. He declined to define what “underserved” means to him; however, he did say that the exchange wanted to address market fairness issues and focus on U.S trading.
“We want to carve out niches that are underserved and have identified several of them,” Kerin said. “First, we need to build up some of our infrastructure to get this order flow.”
Retail order flow
Kerin explained that as the equity marketplace went electronic and gave birth to the wholesaling industry, the CHX ceded its retail order flow and specialists to the likes of KCG, Citadel and Susquehanna. As he told Traders, when CHX specialists left, so did retail order flow.
Wholesalers pay retail brokers for their orders and make markets in stocks. It is this order flow CHX wants back. And so far, one group has begun to migrate back.
“Our former specialists have come back to us, in some cases after nine years, and brought back ideas for us,” Kerin said.
CHX still has a brokerage commission structure that services single-sided trades and crosses, which come from the complex multi-legged execution from the area’s options exchanges. This is how CHX has been able to keep its lights on and pay its bills, he added.
Also, the exchange doesn’t charge for its real-time depth-of-book market data feeds, as is the case with its bigger counterparts, and has no plans to do so. Forgoing the $50 to $100 per-unit terminal fee that can be charged for exchange market data might seem as though CHX is leaving a lot of money on the table. After all, its competitors have embraced the market data feed model amid shrinking equity trading volumes.
“We have no immediate plans to change this model,” Kerin said. “We see exchanges selling market data as problematic because it competes with the SIP’s (Securities Information Processor) sale of market data. There is an inherent conflict because the exchanges serve on the boards of the SIPs they are in competition with.”
He added that CHX supports the idea of the SIP and would like to distribute its depth-of-book via the SIP, if possible, someday.
Fewer Order Types
That is not to say that CHX hasn’t been beefing up its technology offering. The exchange is adding to its list of order types and routing mechanisms to modernize its trading system. Kerin explained that currently, CHX has a simple order type palette: market orders, limit orders and cross orders. That’s it. And it lists only 22 order modifiers.
In contrast, last August NYSE/ICE Chairman Jeffrey Sprecher announced that his exchange would abolish 12 order types and eliminate five other ways to modify trades. This pairing of order types and modifiers was rooted in public criticism that too many order types confuse or over-complicate trading and benefit only high-frequency or the savviest traders.
“Our order type list is simple and always has been,” Kerin said.
Simplicity just might be the key to winning the confidence of the retail trader, who has recently felt burned and alienated from the current market structure, and has read the Michael Lewis tome Flash Boys and agreed with its assertion that the equity markets are rigged.
Kerin also added that the exchange is not bringing back the specialist.
But CHX is making sure its connectivity and technology are competitive. The bourse operates two data centers – one in Chicago (Equinix’s CH2) and the other in Secaucus, N.J. (Equinix NY4) – that handle trading every day. This enables CHX to trade 70 securities in Chicago and 8,000 others in New Jersey.
“We trade everything that New York, Nasdaq and BATS trade,” Kerin said.
This wasn’t always the case. In 2006, CHX closed its floor operations and sold part of itself to several financial firms, including Goldman Sachs and E-Trade, for a $20 million cash infusion that helped the exchange overhaul its systems. However, trading volumes continued to plummet.
As part of its technology transformation, CHX entered into an agreement with technology vendor Informatica in 2013 to replace its older messaging system. Via Informatica’s Ultra Messaging System, CHX can now process equity orders and market data feeds with sub-millisecond response times, enabling unimpeded information flows and near-instantaneous order execution. The technology upgrade also has helped CHX substantially decrease its costs and eliminate single points of failure for more reliable service delivery.
Prior to using Informatica, CHX used an internally developed Transmission Control Protocol (TCP) messaging solution.
Courting the HFTs
While it might seem that CHX is looking to be an anti-HFT exchange through its paring back of order types and beefing up its technology, it is not.
Kerin plans to bring order flow back to 440 South LaSalle Street, at least in part by welcoming these traders. He told Traders that while some market participants have a problem with the HFTs, Chicago doesn’t. While he acknowledges some predatory traders have hurt the marketplace, not all HFT is bad. And based on that, their business is welcome.
“We have no issue with them; HFTs are painted with a broad brush,” Kerin said. “HFTs are the modern-day market-makers on the exchanges, and on our marketplace they add value, put up quotes, add liquidity and tighten up the market. They do good.”
Cash on the Table
For all the change going on at CHX, is it enough to stay relevant, as Kerin put it, or stay competitive in the current market structure? Kerin thinks so, as does Spencer Mindlin, analyst at Aite Group. But Mindlin said a lot depends on the future.
Mindlin did acknowledge that as a regional exchange away from the Eastern U.S., CHX has the backing of Midwest firms who are comfortable dealing with a local exchange that has been around for more than 100 years and is sensitive to the area’s needs. And by bucking the trend seen at NYSE/ICE and NASDAQ OMX, which are expanding their global presence and increasing the types of assets that trade on them, CHX can focus on areas that the larger exchanges miss or fail to serve.
“Most of the exchanges and market centers today are looking globally and into new asset classes,” Mindlin said, “And I don’t think CHX can do this. But if everyone else is looking elsewhere for business, then from sheer neglect a niche opportunity can present itself for CHX.”
Also, being an exchange has its own value, Mindlin added. Given that there are only three major exchange groups, a fourth alternative like CHX can find clients who want to trade there. CHX can also capitalize on the recent government oversight that looks to foster competition among exchanges to keep the market structure competitive – having only a handful of exchanges runs counter to this.
“The upcoming suite of proposed regulatory changes could also create opportunities for CHX,” Mindlin told Traders. “If you get a Trade-At rule or larger tick-size pilot or Payment for Order Flow reform, these changes could create opportunities for CHX to respond as volume is going to be channeled back to the lit exchanges. This includes CHX.”
However, the Aite analyst did note that CHX has its work cut out for it. “On the face of it, CHX can’t stay too small and be a credible venue,” he said. “You’re either growing or dying in the exchange business these days. It’s really hard to stay under the radar and yet stay afloat.”
Also, given the small size of CHX, Mindlin noted that the bourse simply might not have enough cash to upgrade its systems or technology. While CHX’s Kerin said that the exchange was upgrading its technology, he didn’t disclose any particulars.
“We’re trying to add functionality now and will use this functionality for our strategic initiatives going forward,” Kerin said, noting that the exchange’s previous retail clientele didn’t require lots of technology. He also added that CHX would be adding staff, but didn’t disclose who or how many people he’d be adding in 2015.
“How big a budget do they have, especially versus the rest of the market that has already upgraded its systems?” Mindlin asked. “And are they able to respond to the next round of market structure changes? Do they have the budget now to make big tech expenditures?”
Time has not been kind to the CHX. Its annual revenue has dropped to about $17 million with a $1.5 million loss in 2012, according to an SEC document. Still, despite the challenges, Kerin and CHX are undaunted. As Kerin put it, “We see the opportunities and are looking forward to 2015.”
