Exchange Mergers, Or “Pump Up The Volume”

Forgive us, please: today’s morning note is a long one. Feel free to listen to some music while you read:

M.A.R.S Pump Up The Volume circa 1990

Yesterday we were treated to news that the LSE and TMX are looking to merge, as well as the NYX and Deutsche Bourse. We listened as Wall Street analysts opined on CNBC how the NYX / Deutsch Bourse proposed merger was natural, good for all shareholders and parties, and good for liquidity, and therefore markets in general. We thought on that quite a bit.

Without doubt, the NYX – Deutsche Bourse combination will be an exceptionally powerful derivatives exchange; it will provide perhaps the last real opportunity in electronic trading to form a monopoly-like cash machine. Scott Wapner on CNBC had this right all day yesterday, and hats off to him; the merger is about derivatives dominance. For shareholders of the both companies, the NYSE and Deutsche Bourse, this deal is a home run. Why? Effectively we will have the largest futures exchange in the world (yes bigger than the CME/CBOT which control 99% of the US Futures market in their listed contracts), and because of the synergies of having one clearing house, the amount of revenue and technology cost savings will be substantial. Oh, and regarding options, NYX and ISE have about a 40% market share in listed options (Deutsche Bourse owns Eurex, which owns the ISE, which in turn owns 31% of Direct Edge incidentally).

Will the regulators let this stand?  When the CME and CBOT combined into one entity, and then subsequently with the NYMEX, they effectively locked up 99% market share of the futures market, and the argument of fungibility was brought to the forefront. The DOJ did not attempt to make CME move their model toward fungibility, and so effectively, the CME has a regulatory (via the Agricultural Committee) monopoly on US Futures. Liffe and Eurex will share a similar advantage in Europe: the long end of the curve, the short end of the curve, and equity index futures all in one big clearinghouse.  Regulators will probably allow the deal, as Liffe and Eurex will argue that their competition is the CME and the OTC market, and thus they have plenty of competitors.

While we do understand that this is a wonderful deal for NYX and Deutsche Bourse shareholders (refer to the chart at the top of this note to see why), and if I were an exchange executive, I’d want to get “get me some” as well. However, we have some concerns. Exchanges have been on a bacteria-like fragmentation frenzy post REG NMS. We have written about this quite often, about how Exchanges are fueling the need for their own high-margin server farms and colocation revenue by subdividing. The more arbitrage opportunities they can create for ultra-short-term traders, the more volume those traders will pump into the machine. It worked quite well, as those HFT firms (among whom you can count the largest banks and brokers) have been earning billions of dollars, until May 6th. Since then, investors have fled the markets, only recently to start returning. And a pool with numerous parasites and few hosts makes nobody any money. We today have 13 different exchanges in the US, with nearly 40 dark pools (ATS’s, crossing pools, ECN’s, and internalization pools). Nothing, including HFT-courting, as seemed to thwart the stock price declines in NYX since REG NMS was implemented. Actually…umm HFT-courting has exacerbated the equity market low-margin problem; they brought this upon themselves.

Where are we now? Margins have been eviscerated from the equity markets. Brokerages that have provided after-market support and research for IPO’s have been weakened and diminished in number. The focus and catering to short term hyper trading by exchanges has helped those types of firms flourish, at the expense of other business models. Spreads have shrunk. Margins for firms that engage in equity trading have plummeted. We all solved the problem of how our family and friends need to trade for less than the price of a pizza, but we traded it for larger problems and issues.

Fast forward to 2011 where the exchanges (with help from the SEC), have created a horribly low margin equity trading model. Their catering to HFT has ripped through our equity markets, and left them barren, and the same exchanges are all now moving on to foreign equities, derivatives, and swaps. What will happen when the US exportation of the “Pump Up The Volume” HFT parlor trick will leave those equities overseas also barren, and eventually, the derivatives as well? What will there be to move on to then? At what cost? What will be done to capital formation?

This deal rubs us the wrong way in three areas, and we have a few questions we hope you will ponder with us.

–          Pride: The New York Stock Exchange is a symbol of American Capitalism. We remember 9/11. We think proudly of all the great corporations that listed on the NYSE because it meant something. Go ask corporate IR departments about whether or not where they list is/was important.  Listing on the NYSE has always meant safety, prestige, disclosure, and credibility.

–          National Security: Mahwah is considered “critical infrastructure” by Homeland Security. Are taxpayer funds used for protection of this public entity? Will taxpayer funds be used to subsidise a public entity that is headquartered overseas? Is that appropriate? Will German guards then guard Mahwah? And even if taxpayer funds are not used, can we rely on the for-profit model to protect the markets from cyber-attacks, such as those last year on the LSE, and this past weekend at NASDAQ. Will the exchanges put that safety above their short term profit motives? Or will they subvert that investor protection as they did with the data feeds and flash orders?

–          Regulation: Which regulators will make the rules? Whose standards and legal systems will have jurisdiction? Will trading hours move to 24-7, as the machines can run all day long with proper cooling? Will the units be run to maximise profit or to maximise the utility function of the exchange? The legitimate question for regulators is, “does the for-profit model work in conjunction with the utility function of exchanges?”

–          What will investors get? Tighter spreads (insert laughter here)? More “liquidity” (insert hysterical laughter here)? A European market that has futures liquidity in one venue, and cash liquidity in over 50 venues? Bad pricing signals as there will be a great increase in volume, but not in liquidity?

I suppose NASDAQ will call and see if they can get in on the commodities exchange known as the LSE/TMX. As we all see clearly, it is about high margins and monopoly pricing powers in this next wave of market structure change. That is, until the “Pump Up The Volume” trick renders those businesses to be toss-aside-low-margin-barren-crap businesses as well, as it has our equity markets.

Well at least we have time, as Washington is shortly handing SWAPS over to the exchanges, and then we can have highly leveraged HFT trading highly derivative SWAPS with HFT efficiency and hot potato liquidity. So much for capital-raising. The focus is on trading yet again, and trading at all costs.

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