The Incumbent Exchanges

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With Tal Cohen, CEO Chi-X Global

Where you have entrenched monopolies or incumbents their businesses have grown into concentric circles with their customers, in which the customers and exchange have a very close relationship. When a new competitor comes in to town, there’s a level of inertia that must be broken in order for viable competition to take hold.

There may be significant hurdles in terms of breaking culturally ingrained habits for start-ups to overcome. It’s not just the rival of competition that drives a change in behaviour. Often what is required is a catalyst to overcome the inertia, which enables competition to showcase its value, and drive firms to change behaviour and take advantages of competition.
That’s not to say that the member firms are not doing the right thing, it simply highlights the fact that their infrastructure, technology, and workflows are designed over a long period of time and it takes time to recalibrate that to embrace a multi-market environment.
When launching an alternative market, you need to present a value proposition through innovative products and solutions that meet industry needs. It can start with bringing better technology, being more cost-efficient, improving investor performance or through the advocacy of positive regulatory reform.
Competition enables market constituents with different investment needs and different time horizons, a variety of options for interacting in the market. In a single market environment meeting a diverse set of investment needs is difficult, so with a monopoly it’s almost like the early days of cars in which Ford with the model “T” stated; you can have any colour you want as long as it’s black.
It’s not about taking the pie and slicing it in half, it’s about growing the overall market, identifying trends, identifying customer needs that a single market model, especially in a regulated environment, can’t possibly satisfy.

Finding the balance of fragmentation

To compare and contrast Australia and the US; in Australia, the benefit of competition is well understood and appreciated. In Australia we’ve forced ASX to raise the level of its game. They have pushed out new products, lowered pricing and become more responsive to customers. Because of competition they fragmented their own market and now they run three books in an effort to meet industry needs. The expansion of choice has brought about a positive change for the market’s constituents by lowering costs and increasing choice. And so that level of competition has been healthy. Now, the challenge with competition as it evolves, and this will bring me into the US, is that the markets become more complex. As you continually try to innovate, you run against the efficient frontier where there may be diminishing returns with each additional entrant into the market. For some of the new businesses that are challenging the status quo, technology can get you in the game; it doesn’t necessarily differentiate you. In the more mature or developed markets its difficult to innovate without really changing the rules of the game.
Asking regulators to change the rules of the game has the potential to create an environment in which reforms determine the winners and losers or could lead to regulatory arbitrage, and I think regulators should have it as a goal to avoid doing so when they look at how market microstructure should evolve.
Generally, regulators are looking more and more like technology firms. The regulators need different skill-sets and tools; they need to invest much more in technology than they did ten years ago. Market manipulation hasn’t really changed all that much, but the techniques and the mechanisms with which they monitor and detect it are very different.

Changing the exchange model

One reason for the change in exchange models is because the economics have forced them to change. Fundamentally, they’ve brought down the price of doing business when it comes to execution and clearing. The model was to bundle services, and this bundle was expressed in execution fees. Now that execution and clearing fees have come down, how can you reverse the commoditisation of the service?
The exchanges, very much like brokers, have unbundled their services and are being forced to examine the value they provide to the Street. It’s going to be a process in which they learn by obtaining feedback from their clients and better understand where the real value of an exchange is.
And this is the challenge; their fundamental premise and reason for being hasn’t changed. They are there to service issuers and investors. They serve in some respects in a utility function by enabling issuers to raise capital and in the secondary market by allowing investors to effectively transfer of risk. What is now being debated are the products, services and technology by which they provide those services. And then on the other side of that is, what risks are being taken while commercialising themselves. There needs to be a balance.