This Is No Way to Run the U.S. Stock Market
When my employer, IEX Group Inc., received its stock exchange license two years ago, I gained a seat on the committees that oversee much of the critical infrastructure of the U.S. equity markets. From that insider’s perspective, I’ve come to a troubling conclusion: Private interests are corrupting the markets’ public purpose.
Most of my fellow committee members, who are good people, will not appreciate these comments. But I think they need to be said.
In 1975, Congress enacted a huge rewrite to the securities laws, with the goal of stitching together a new national system from the loosely connected markets that existed at the time. As part of those changes, the Securities and Exchange Commission gained authority to require so-called self-regulatory organizations — including stock exchanges and what is now the Financial Industry Regulatory Authority — to work together to realize that vision.
The SEC divided the work into tasks known as national market system plans, each with its own committee. The original plans — securities information processors — involved disseminating data on stock prices and trades to the public. Others have been added over time. One is developing the consolidated audit trail, a detailed record of market activity designed to help root out bad conduct and ensure that rules are followed. Another governs trading limits that keep prices from moving too far too fast. Another is exploring whether to change the one-penny minimum price increment for some stocks.
Initially, the organizations that managed the plans were somewhat representative of the financial community. The exchanges were industry cooperatives owned by the same financial service firms who used them. Over the next 40 years, though, ownership structures and incentives changed dramatically. Today, the large exchanges are all parts of public companies focused more on increasing profits for the benefit of their shareholders than furthering the interests of market participants.
Meanwhile, the governance of the plans has remained the same. The operating committees consist solely of self-regulatory organizations. This gives the large exchange companies (each with multiple exchange licenses) the most power, because they get one vote for each exchange they own. Advisory committees are supposed to bring in outside views, but they don’t have a vote. Advisers who make too much noise or ask too many questions can be kicked off the island. Believe me, I’ve seen it happen.
Why does this matter? Consider a few examples.
The exchanges, acting through these committees, don’t distribute “public” market data for free. Rather, they set fees and share the revenue from feeds that brokers and other vendors must subscribe to. They have little incentive to reduce fees or to invest in the product. Only recently did the relevant committees start disclosing how much revenue each exchange receives. They still don’t disclose how much money the public data feeds take in, or how much is put back into improvements.
More important, the exchanges make a lot of money selling their proprietary market data. So they have no reason to want the public data to improve in ways that undercut this business. For example, one exchange has blocked a proposal that would allow any listing market to include data from opening and closing auctions in the public feeds. Separately, some advisers have proposed replacing the current public data system — consisting of two processors controlled by NYSE and Nasdaq — with a system of competing processors. The committees won’t even discuss that one. Seriously, it’s like the Proposal that Dare Not Speak its Name.
Then there’s the consolidated audit trail, or CAT. This project is critical to giving regulators the data and tools they need to monitor trading. But if exchanges don’t want or don’t think they need better surveillance tools, they won’t work very hard to create them. They certainly don’t have much incentive to build a system that the SEC can use to monitor their conduct more effectively. In making design decisions, committee members have every incentive to focus on their own costs to build and use the system, rather than on how much those decisions will cost all the other firms that have to supply data.
To make matters worse, there are no policies, procedures, or understandings about how to manage or mitigate these conflicts. Never have been. As far as I can tell, I’m the first committee member to ask if there should be.
What should be done? The simple and direct answer: Give other stakeholders, such as investment funds, brokers and retail investors, a voice and a vote. In 1996, the SEC forced the National Association of Securities Dealers to adopt a “balanced” board, after it failed to stop collusive pricing. The crazy irony is that today, all the exchanges are required to have balanced boards for their own governance. So why shouldn’t the governance of the market infrastructure be balanced as well? Why should the companies that control the exchanges be free to run “utility” functions for their own benefit?
Those same companies argue that under the law, only self-regulatory organizations can be members of the plans. But the law simply states that the SEC can require those organizations “to act jointly” to meet the law’s purpose. It doesn’t say everyone else must be excluded. The exchanges also say it would be unfair to give outsiders a role in shaping obligations that fall on them. But controlling half the votes is plenty of protection against getting steamrolled, and any significant proposal still has to be approved by the SEC. If any exchange objects, it has a right to be heard. The unfairness lies in running public projects like private fiefdoms.
It has been 40 years since the national market system plans were created, and more than 20 years since the NASD adopted a balanced board. How many more years will it take to update these plans so they serve all the people who have a stake in fair and efficient markets?
To contact the editor responsible for this story:
Mark Whitehouse at firstname.lastname@example.org