Wall Street kicked off the new year with a bang, with news of major US players banding together to take on incumbent exchange operators with a potentially game-changing move.
Nine institutions encompassing retail brokers, banks, global market makers and an asset manager, have agreed to launch a new equities exchange, known as Members Exchange, or MEMX for short.
Details at this stage are vague, but what we do know is that MEMX aims to reduce the fixed costs of trading and simplify execution in the US equities space through basic order types, a low-cost fee structure and the latest technology.
Some industry experts and analysts have deliberated that the development is hardly shocking and more of a cyclical industry trend. Aite Group analyst, Spencer Mindlin, summarised the trend within a blog post on the news, explaining that over the past 20 years, the US exchange industry has been through two major arcs of modern market fragmentation and consolidation.
The trend saw the rise of consortium-led challengers in the form of BATS and Direct Edge, which chipped away at incumbent exchange market share by catering for the next generation of traders. The market has now consolidated itself down to three major exchange groups: NYSE, Nasdaq and Cboe, with one independent exchange – the Investors Exchange (IEX) – alongside various Alternative Trading Systems (ATSs) and dark pools.
“Each time a new entrant was successful, it was in part because its interests were in line with its members and because it had members represented in its cap table,” Mindlin said. “It may look like a rinse-and-repeat exercise when a consortium of banks, brokerages, and high-frequency trading firms band together to launch a new US exchange such as MEMX. But the market’s structure is different than it was the last two times.”
Considering the backdrop of bitter debates between Wall Street and regulated exchanges on the costs of data and access, launching an exchange focused on lowering fees and simplifying market structure clearly indicates that MEMX’s interests are aligned with its members.
But those members, including Bank of America Merrill Lynch, Charles Schwab, Citadel Securities, E*TRADE, Fidelity Investments, Morgan Stanley, TD Ameritrade, UBS and Virtu Financial, could have a long road ahead.
Alasdair Haynes, a veteran exchange executive who has first-hand experience of challenging incumbent exchanges as a leader of Chi-X and, more recently, founder of Aquis Exchange with its unique subscription-based pricing model, told The TRADE that MEMX must make its mission clearer.
“There needs to be a good reason for setting up a new exchange,” Haynes explains. “You have to be able to offer something that is substantially different and better than the status quo. Just doing the same thing for a lower price isn’t necessarily going to be enough to get people to switch.
“We simply don’t know yet what MEMX plans to do that’s original. So far they have only talked about offering lower fees and that won’t be a paradigm shift like Chi-X was with fast pan-European trading, or Aquis with subscription pricing.”
Haynes added that the only realistic way for MEMX to get to market quickly and to be genuinely low-cost is to bring in an efficient and independent technology provider. If it takes the in-house route the consortium risks being subject to internal politics, while buying its technology from a rival like Nasdaq could see the venture become a non-starter. Projects like MEMX also have a bad reputation in that they are notorious for being expensive to run, and slow to make progress.
“There is a long history of groups of rivals forming consortia to launch ventures for the ‘good of the market’. These don’t often succeed as the constituent firms continue to be rivals in every other aspect of their business and don’t easily adapt to co-operative mode,” said Haynes. “Also, in the case of MEMX, many of the firms have strongly contrasting ways of trading and finding a formula that will suit all the participants won’t be easy.”
Despite the challenges ahead, many in the industry are relatively bullish on MEMX’s future success considering the reach and market share that the founding members have.
Aite Group’s Mindlin said that he believes MEMX has a good chance of winning market share from the likes of NYSE, Nasdaq and Cboe. The consortium-owned exchange is largely being led by Virtu Financial and Citadel Securities, which together hold around 40% of order flow in US markets.
“He who controls the market’s liquidity controls the market,” Mindlin said. “With the members as owners of MEMX, the exchange should be able to build the market and fee structures in their image. On the surface, it seems like the owners are in good positions: Start a new exchange, route your order flow to it; maybe you exit, and maybe you don’t.”
Larry Tabb, Tabb Group’s research chairman and founder, also believes MEMX has a good probability of success, but warns that it isn’t a ‘slam dunk’.
The founding members include two of the largest proprietary market makers, three of the largest retail wholesalers, four of the largest online brokerages, three of the largest retail warehouses, and three of the largest institutional brokers. Or, in other words, you have firms that quote, firms that execute for retail and institutional firms, and the major retail brokers themselves, Tabb told The TRADE.
“It’s a very impressive line-up of firms, but that said, unless you can post very aggressive quotes, it becomes difficult to send market orders to an exchange,” Tabb said. “You can’t send an order to an exchange that can’t give you best execution, so you need to create a conducive environment to post, and then the liquidity takers will appear.
“Once you get the order flow, then it creates competition for the other exchanges to better their pricing and trading environment. So will this be easy? No, but it certainly is doable and fairly likely given the firms involved and the orders that they execute.”
Others in the industry believe that MEMX could be a ploy or bluff to bring the fight on market data and access to the exchanges. But some say that regardless of this, and if successful, MEMX could have a positive impact on markets in terms of the battle for lower costs.
Liquidnet’s global head of market structure, Adam Sussman, wrote in a blog post that the argument the founders are launching MEMX to lower their own costs, and will not pass it back to their investors, is irrelevant.
“It is hard to understand why anyone would think this would be bad for the marketplace,” Sussman said. “If the MEMX is successful, it should lower the costs for all the brokers that connect to the US Exchange market. Remember that US institutional equity commission rates have been falling for years, unlike Exchange connectivity and market data fees. And can anyone seriously complain about increased fragmentation? Fragmentation is like having kids – after you have three of them, you just go numb to the pain.”
If nothing else, MEMX promises to bring competition to the US exchange landscape and gives dealers a seat at the table, so to speak, in terms of the current exchange governance structure.
Looking back on the difficult road IEX travelled in establishing itself as an exchange – although the disputes around IEX were specific to its controversial speed bump, something that MEMX has ruled out – it’s hard to imagine that Nasdaq, NYSE and Cboe will welcome MEMX with open arms to the exchange industry.
The MEMX founders have said they will file an application with the US financial regulator to operate as a national securities exchange in the early part of this year. Given the proposed timeframe and market reaction amid the development, where incumbent exchanges saw their share prices drop around 2% following the announcement, we can expect to see some major drama in 2019 as the ongoing battle between Wall Street and regulated exchanges comes to a head.