A Different Type Of Exchange

 By Jos Schmitt, CEO of Aequitas Innovations

When exchanges demutualised and became for-profit organizations, it led to a number of unintended consequences that today have a major impact on market quality and capital-raising. One of these consequences is that exchanges, and all their alternative trading platform competitors, now mainly cater to those market participants who allow them to generate most volumes, which translates into revenue.

The problem is that some participants, and some HFT firms in particular, focus their presence in liquid securities, making the market maker business proposition no longer viable. This is detrimental to both long-term investors and to the issuers as market makers are no longer there when the need is the highest; periods of stress, small and mid-cap securities or IPOs. From conversations with industry participants, we see many that want to go back to the roots of what an exchange is and implement a strategy that puts investors and issuers first. Many harbour an ambition to re-establish balance in the market and seek to improve it by proposing solutions that allow long-term investors and issuers to be more successful.

Jos SchmittWe believe that exchanges’ certain behaviour will make true market makers successful again, that a listing venue should focus on ensuring the readiness of corporations going public, that there’s a need for an alternative capital raising and trading venue for small and mid-cap securities, and that an exchange should seek to reduce the costs for market participants in general.

Restricting Inappropriate HFT Behaviour and re-incentivizing Market Makers
In order to restrict predatory strategies, exchanges can use a combination of affordable advanced technology and market structure solutions. One way to drive this change is to use smart order routing to prevent latency arbitrage and quote fading by holding market participants to the quotes they display.

A further market structure solution is an eco-system of liquidity pools where two of them, a dark pool and a transparent liquidity pool, will only allow long-term investors to take liquidity, will prioritise executions in a way that no longer lets time prevail while allowing market makers to be part of more good trades, and will not support the maker/taker fee model. The third liquidity pool in this kind of ecosystem will be a classic lit pool that will prioritise executions in a way that preferences long-term investors’ resting orders. This ecosystem will prevent rebate strategies, exploratory trading and technological front running, while promoting larger trades.

Should a new exchange tackle the HFT issues or should this be left to the regulators?
We believe that regulators should focus on investor protection and market integrity, but that when it comes to market quality, commercial initiatives should provide the solutions. There is a lot of debate about HFT firms, with its proponents and its opponents, so why not let market participants decide for themselves by providing them with choice, true choice? Having regulators micro-manage behaviours can lead to many unintended consequences, not to mention that change is permanent.

Another initiative that is being driven by industry feedback is focused on the capital raising process with a two-fold strategy. A public listing venue that will only allow for the listing of senior corporations; corporations that at are at a stage in their development where they can handle the burden that comes with a public listing, where they can generate investor interest to fuel natural liquidity and analyst coverage, and where being listed is a proposition that will allow them to successfully support future capital raising needs. This can be complemented with a private market tailored to the individual needs of small and mid-sized corporations where they will have efficient access to risk tolerant investors and secondary liquidity.

Across these initiatives, there is a drive to focus on reducing the cost of doing business for market participants. This will be achieved through competitive fees, challenging the maker/taker fee structure, providing affordable technology solutions, and developing to new solutions in the market data space.

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