The Stock Market Needs Another Exchange Like It Needs a Hole in the Head

Shah Gilani|January 29, 2019

As if thirteen so-called “exchanges” and forty “dark pools” aren’t enough, here comes the Members Exchange (MEMX).

Founding members of Bank of America’s Merrill Lynch, Morgan Stanley, UBS Group, Charles Schwab, TD Ameritrade, E*Trade Financial, Fidelity Investments, Citadel Securities, and Virtu Financial claim the new trading venue slated to open in 2020 will feature lower costs, greater transparency, and simplified order types.

Seems all well and good, but what they’re never going to admit is why they’re really pushing another exchange into an already fragmented, liquidity draining, churning ocean of viciously competing trading venues.

But I’ll tell you.

And you might not like the truth…

Just Because It’s Legal Doesn’t Mean It Should Be

If you heard about MEMX and think you know why these “members” are forming a new exchange – because you think as a licensed exchange they would get a cut of the more than $400 million annually in market data revenue fees the Big-Three licensed exchanges bag every year – you’d be right.

That’s one reason. I’ll get to the other shortly.

Intercontinental Exchange (ICE), which owns the New York Stock Exchange, Nasdaq, and Cboe Global Markets, controls 12 of the country’s 13 exchanges and more than 95% of trading volume.

Because they print so many trades, they have price data that everyone wants and must pay for.

MEMX wants to help create some of that volume and get a piece of the money the Big-Three get when charging for access to their price data.

Sounds reasonable, doesn’t it?

But that’s only half the story – and not the honest half, either.

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It’s not about collecting price data on trades that get executed at your exchange and charging for that data.

It’s about seeing prices, seeing bids and offers travelling through everyone’s pipes on the way to the exchanges for execution – before anyone else sees them, before they get executed.

It’s about order flow, as it has been for a very long time.

It’s about reading those orders and front-running them – legally, of course…

… I’m half-kidding about the “legally, of course” thing.

It is legal, but it shouldn’t be.

It’s front-running.

MEMX wants to have their members, increase the number of members in their enterprise, and send all their orders to one place to have them executed – to MEMX, of course.

In case you don’t know, E*Trade doesn’t execute the orders its customers send through their trading platforms. Nor does Fidelity or TD Ameritrade, or any so-called discount broker.

Most small and medium broker-dealers don’t execute customers’ orders. They send them to different exchanges directly or to intermediary market makers like Citadel Securities or Virtu.

They send them to different exchanges and different executing houses because they get paid to send them there.

That’s why your order execution costs are so cheap.

You may pay only $5.00, but your broker is also getting paid cents per share to send your orders somewhere to be executed.

Even big bank brokers like Merrill Lynch sometimes send customer orders elsewhere to be executed if they’re not big enough for them to make money on them.

The Market’s Rigged – Believe It

The reason there are so many exchanges is that they compete for business by offering to pay to get brokers’ order flow sent to their exchange.

There are two giant problems with selling order flow to competing exchanges.

First problem, the market’s biggest problem of all, is the lack of liquidity that exists because orders are split up and sent all over the place (the average size order now is for only 150 shares).

If all orders to buy and sell the same stock ended up in the same place (call it a centralized book), big orders would be able to be executed much more efficiently. Then investors and traders would be more inclined to leave standing buy and sell orders down in the central book to be executed when their prices are reached.

That would increase market liquidity exponentially and make market moves in both directions much smoother.

The other problem with fragmented exchanges is trading shops with superfast computers get into the pipes where orders are sent to the exchanges for execution. They read those orders before they even get to their destination for execution.

Yeah, they read your orders, and they front run orders by buying or selling before you.

More importantly for them, they see orders coming. If they see lots of buy orders coming, they can take advantage of that order flow by buying shares. If they see lots of sell orders coming, they will sell ahead of us and be in position when arriving orders to sell knock down the prices of stocks they’ve just shorted.

The market’s rigged. Believe it.

If MEMX gets all its members to send its electronic exchange all their order flow from all those brokerages, then the members of MEMX can front run their own customers’ orders and make money for themselves off their own order flow.

Back to reason one.

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About those data fees that MEMX wants a share of: Sure, they’ll get a bigger cut of the fee pool they collect when they sell everyone the price data that’s printed at their exchange, as opposed to exchanges owned by the Big-Three.

But, it’s reason number two, that they will actually make prices by trading off the order flow they direct their way that makes starting another exchange a no-brainer.

If the SEC was honest, and I’m not saying they aren’t, but figure it out for yourself, they wouldn’t allow trading shops to co-locate their servers next to the exchanges’ servers, so they can read the order flow in their pipes.

Which is expensive for trading shops and MEMX members including Citadel and Virtu who want cheaper access to friendlier servers.

Get it?

And, the SEC would have by now created a centralized book.

But that’s about making markets safer and more liquid, and not about aiding and abetting the SEC’s constituents, the broker-dealers and exchanges the Commission protects, aids and abets.

Sincerely,

Shah