FLASHBACK FRIDAY: Above the Law – What Exchanges and Kings Have in Common

For the most part, its always been good to be a King. The same can be said of being a public stock exchange – lifes been good.

But why should life be so good for royalty and the exchanges? What have they done to merit such favor?

As Traders Magazine delved back into its archives it came across the following commentary by one-time contributor and well-respected market veteran Dan Mathisson – but also consequently worked for Credit Suisses Advanced Execution Services group. Mathisson also ran Crossfinder, the banks ATS, which put him often at odds with his exchange competitors for order flow and market supremacy. Back in 2012, he was engaged, often publicly, in heated debate on the merits of ATS trading and how exchanges enjoyed many many perks – including preferable treatment from the government when it came to legal matters.

Fast forward to now and things look awfully familiar. Debate about the exchanges conduct their businesses – being for profit and yet policing themselves remain debated. Their ownership and alleged monopoly on trading data is also hotly contested by many in the marketplace.

The US Securities and Exchange Commission is now turning a sharper eye toward exchange governance, which has been on its back burner for too long, according to one commissioner. Market data access fees and the self-regulatory organizations limited immunity likely will be reviewed in depth, Commissioner Robert Jackson told Traders Magazines sister publication Markets Media.

I hope to get to exchanges at the top of the list because they have been left unaddressed for so long, he said.

Jackson noted that Brett Redfearn, director of the Division of Trading and Markets at the SEC, has announced his divisions plans to hold industry roundtables on SRO governance, which will include market-data pricing and other issues.

The Commissioner also would like the regulator and its staff to take a deep dive in review SRO immunity for a possible update to reflect the current governance of the exchanges.

The reason for this is because when the regulator first established an SRO model, exchanges were mutually owned organizations, he said. Now, they are privately held and do what privately held businesses do, which is pursue profits.

Commissioner Jackson questioned why profit-making institutions should wield government immunity that prevents them from being accountable for mistakes that harm investors.

He cited Nasdaqs botched initial public offering of Facebook in 2012, which market makers estimated cost them about $500 million, but the exchange operators ultimate payout was only a bit more than $75 million total covering a voluntary payment, fines, and a legal settlement.

As long as exchanges keep making profits for private shareholders, they should be held accountable for any harm they inflict by mistake, according to Commissioner Jackson.

Exchanges cannot have it both ways, he said. They cannot keep profits for their private shareholders and then expect to be able to hurt people and not be held accountable. It is one or the other – either they are the government, or they are a private profit-making institution.

The point was echoed also by J.W. Verret, associate professor of law at the George Mason University Antonin Scalia Law School. Focusing on the data fee issue, he said that in recent years and across a multitude of policy areas, Washington policymakers are asking questions about who owns the data you provide through online apps or via payment methods. A brewing debate about data fees at big stock exchanges like the New York Stock Exchange (NYSE) stands to turn that analysis on its head, and he argues, merits a response from the SEC.

Well, the SEC is listening – finally.

The big exchanges now generate more profits from selling data and connectivity concerning the trading of securities than from the trades themselves, he began. It wasnt supposed to be this way: The 1975 amendments to the Exchange Act in question also gave the SEC authority to police the prices and fees charged for stock market data to guard against any anticompetitive behavior on the part of the exchanges. They have been credibly accused of such behavior.

The current system for market data on stock market trading certainly isnt optimal, he added, but as long as it provides large exchanges with a monopoly right over trading data, the SEC should ensure that right is not abused through discriminatory pricing.

Further, the SEC shouldnt allow any data fee increases until the access fee pilot study is completed, and we have an opportunity to chart a new course on market structure reform, Verret said.

Commissioner Jackson envisioned any review process regarding SRO immunity to a consultative and contemplative one with input from market participants and ordinary investors.

I do not imagine that anything would happen overnight, he said. It took a decade or more for us to get to this problem.


But there is hope. And the industry, except for the exchanges, are hopeful.

These comments should send shivers up the spines of executives at the three major, publicly-traded stock exchange families (NYSE, Nasdaq and Cboe) especially in light of the outstanding City of Providence class action case where exchange immunity has come into question, wrote Joe Saluzzi, partner at Themis Trading in a recent blog. Thirteen years after the passage of Reg NMS, the SEC seems to have finally had enough of the conflicts of interests that this regulation helped create at the major stock exchanges. Reg NMS assisted in turning these once non-profit, self-regulatory bodies into for-profit entities that have created unfair edges for their highest volume clients at the expense of long-term investors.

Themis continued that the notion of absolute immunity has allowed these exchanges to operate for-profit businesses while receiving the valuable protection of immunity. Even though they are now essentially data vendors and no longer perform many SRO functions, exchanges have continued to enjoy this regulatory protection – until now.

Saluzzi predicted the exchanges will fight vigorously to maintain their immunity status. He noted that there is currently a bill in Congress, H.R. 3555, which seeks to change the Exchange Act to redefine the facility of an exchange and strip out certain stock exchange activities from SEC oversight. It was introduced by Rep. Barry Loudermilk from Georgias 11th District, NYSEs parent company ICEs home district.

Were glad to see that Commissioner Jackson has the exchanges in his crosshairs and we hope this encourages the major exchanges to rethink some of their questionable behaviors now, Saluzzi said.

And while Dan Mathisson has left the trading business, his resistance and critique of the exchanges remains. Somewhere out there, he might even be heard chanting, Vive la rsistance!

The following article originally appeared in the August 2012 edition of Traders Magazine

Above the Law – What Exchanges and Kings Have in Common

By Dan Mathisson

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.”