Regulator Hands Are the Devil’s Workshop
Until I read this post by Nasdaq chief economist Phil Mackintosh I was unaware that the SEC wants stock exchanges to adopt cost-based pricing. Even by regulator standards–and Gensler-era SEC standards in particular–this pegs the Dumb-o-Meter.
It is dumb on many levels. Full spectrum dumb.
For one thing, why would the SEC want cost-based pricing? Presumably because it believes that exchange prices are too high. Why would that be? Market power presumably.
But in the electronic era, and ironically especially in the post-RegNMS era, there is substantial competition between exchanges, and between exchanges and the OTC market. Here’s a chart of trading volume and shares by venue for the last 5 days (found here).
Note that exchanges account for less than half of total volume, with a majority of trading taking place on the OTC market. Even among exchanges, volume is fairly well split, with the NYSE having the biggest share (roughly 1/3 of exchange volumes).
This volume split reflects the competition that resulted from RegNMS in an electronic environment. Given this competition, excessive exchange profits should be the least of the SEC’s worries.
Even if market power was a concern, the idea of cost-based pricing would be inane. Exchanges have fixed and variable costs. Price structures must cover both, but average cost pricing leads to inefficiencies: the price of the marginal trade should equal marginal cost, but marginal cost is virtually impossible to measure. And with fixed costs, it can be efficient to utilize variants of Ramsey Pricing in which prices deviate from marginal costs, and for multi-product firms the deviations between price and marginal cost vary by product. (Exchanges are multi-product firms, offering transaction services, data, listing, and other services). (The SEC might also want to catch up with the economics literature, starting with Coase’s The Marginal Cost Controversy, which is only 78 years old).
Moreover, as Mackintosh notes, exchanges are platforms–though he doesn’t explicitly point out the key fact that they are two sided platforms, as most matching systems are. A crude taxonomy of the two sides in the exchange context is liquidity suppliers and liquidity demanders.
As has been known since two sided platforms became a thing (post-Internet, basically) optimal platform pricing structures can be very complex, and optimal pricing structures are not cost-based. To generate the mix of customers that maximizes platform value it is typically the case that one side pays below cost prices (and may indeed pay a zero price or receive a subsidy). In the exchange context, this is most readily seen in maker-taker or taker-maker pricing structures where the exchange fee differs depending on whether you are the active or the passive side of a transaction.
One aspect of inter-exchange competition is that they compete on price structures in order to optimize platform value. Some exchanges even offer different platforms with different pricing structures. This differentiation accommodates the heterogeneity of traders, some who prefer one structure and others who prefer another. In essence, the platforms are competing for different clienteles.
The idea of imposing a cost-based cookie cutter pricing structure on exchanges is therefore beyond absurd. Not only is it unnecessary to constrain market power, any cost-based structure would be wildly inefficient and completely at odds with the basic economics of exchanges as two-sided platforms.
But I guess that’s what you should expect from an agency dominated by lawyers and accountants.
It is ironic that the SEC apparently doesn’t recognize the benefits of one of its major regulatory initiatives of the past two decades–RegNMS. That regulation led to substantial inter-exchange and inter-platform (exchange-exchange, exchange-OTC) competition. One result of that competition is non-cost-based pricing that reflects the fundamental nature of trading venues as two-sided platforms. Thus, exchange pricing is something that the SEC doesn’t have to worry its pretty little head about.
There is a bigger lesson here, relevant to our DOGE era. Parkinson’s Law says that in a bureaucracy work expands to fill the time available. An agency that has the time to pursue such daft initiatives is obviously over-resourced and over-staffed.
Put differently, idle regulator hands are the Devil’s workshop.
Apropos an earlier post scourging Tyler Cowen’s lament that cutting regulator headcount would harm businesses who rely on regulators’ guidance, there have been numerous articles appearing in the post-election days similarly arguing that regulators are really businesses’ friends. They’re from the government, and there to help you! Really!
But as I noted in that post, much of that “help” is necessary only because regulators create the need for helpers by implementing wasteful, complicated, and intricate rules. Cost-based pricing of exchange services could be a poster child for that. It would be economically unnecessary (because competition constrains pricing) and inherently result in absurdities that would have the regulated running to the regulators for guidance and clarification. Regulators creating jobs for regulators, and justifying their existence thereby.
