One of the reddest of herrings is that the movement to for-profit exchanges is the source of our current woes in securities and derivatives markets. The herring were running today in DC, at a hearing on HFT held by the Permanent Subcommittee on Investigations. One of the witnesses, Andrew Brooks of T. Rowe Price testified thus:
We question whether the functional roles of an exchange and a broker-dealer have become blurred over the years creating inherent conflicts of interest that may warrant regulatory action. It seems clear that since the exchanges have migrated to “for-profit” models, a conflict has arisen between the pursuit of volume (and the resulting revenue) and the obligation to assure an orderly marketplace for all investors. The fact that 11 exchanges and over 50 dark pools operate on a given day seems to create a model that is susceptible to manipulative behaviors. If a market participant’s sole function is to interposition themselves between buyers and sellers we question the value of such a role and believe that it puts an unneeded strain on the system. It begs the question as to whether investors were better served when exchanges functioned more akin to a public utility. Should exchanges with de minimus market share enjoy the regulatory protection that is offered by their status as exchanges, or should they be ignored?
This is tripe from beginning to end. The idea that exchanges ever “functioned as public utilities” is a joke. Non-profit, mutual exchanges were clubs that operated in the interest of the brokers and market makers that owned them. Period. The public be damned.
Not-for-profit is not a synonym for public-spirited. As I showed over 15 years ago, exchanges adopted the non-profit form as a way of reducing rent seeking battles between heterogeneous members. It had nothing to do with serving the public interest.
Jeff Carter has a great blog post about how not-for-profit exchanges really operated. He gives some very good examples of something I emphasized in my 2000 JLE piece: the primacy of committee governance as a way of refereeing rent-seeking squabbles between very, very profit oriented members:
Exchanges prior to demutualization were run by members. As a board member, I chaired, co-chaired or served on several committees. I was lobbied constantly by members. I cannot remember the exact number, but I think we had some 200 committees, sub-committees and ad hoc committees. We had 40 board members. It was almost impossible to get anything meaningful done.
Here is an example. We had a rule that if a contract reached an average daily volume of 10,000 or more, in financial futures it could no longer be dual traded. The Nasdaq pit was taking off and somewhere in 1999, it went over 10k ADV. Locals wanted dual trading to end. Brokers didn’t want it to end. As a board (and local), I thought we should end it because that was the hard and fast rule.
Nasdaq brokers threatened to quit if we banned dual trading. The board agreed not to ban it. That doesn’t happen in a for profit environment.
Another example. We needed to adjust a pit configuration. It is tough to put in a blogpost the level of argument that ensued, the amount of committee time and lobbying that took place, and the number of committees that had to check off a relatively minor adjustment. But, that’s the way things worked because real estate was extremely valuable. One foot higher, lower to the right or left could mean the difference between survival and life.
And if you think that there were no conflicts of interest in traditional not-for-profit exchanges, I have several bridges to sell you. And I’ll throw in some Arizona coastline, just to show what a swell guy I am.
With respect to self-regulation, my work from over 20 years ago demonstrated that traditional exchanges had little incentive to adopt and enforce rules that reduced certain forms of inefficient conduct (such as manipulation) because (a) they didn’t internalize the benefits of doing so, and (b) these rules could be exploited to redistribute rents among members, and a primary purpose of exchange organization and governance is to mitigate such distributive conflicts.
Unpublished work, which I might dust off, compared and contrasted the incentives of for-profit and not-for-profit exchanges to self-regulate efficiently. I showed that FP exchanges actually have superior incentives to prevent and deter some forms of inefficient conduct.
But the main point to keep in mind is that there was never, ever, ever, any Golden Age of public spirited exchanges acting in the public interest. Indeed, the entire reason that laws such as the Securities and Exchange Act, and the Commodity Exchange Act, were passed was that exchanges were widely-and correctly-perceived as being extremely flawed guardians of the public interest.
I say again. Not-for-profit exchanges shouldn’t be confused with charities, like the United Way. The non-profit form, and the committee-driven governance that Jeff describes, had one objective, and one objective only: to benefit (greedy) exchange members. Technological changes, specifically the move to electronic trading, eliminated the need for ownership and governance structures that protected specialized intermediaries like locals and floor brokers. Once that happened, exchanges demutualized. End of story.
There are serious issues about the incentives of exchanges, be they for-profit or non-profit, to adopt and enforce efficient rules. That’s where the focus should be. Superficial invocations of some non-existent Golden Age do not advance the debate. They put it in reverse. So let’s give that a rest and focus on the real issues, shall we?