A lot has been written recently about the 3 new exchanges: Members Exchange (MEMX), MIAX Pearl Equities (MIAX), and the Long-Term Stock Exchange (LTSE). To summarize in a sentence, the three new exchanges are analogous to the three Schuyler sisters from the musical Hamilton: MEMX and MIAX being Angelica and Eliza, and LTSE being the mostly inconsequential Peggy. Since the implications of these 3 exchange have been discussed thoroughly elsewhere, I will refrain from piling on. But since I cannot simply end this post here with one brilliant yet pithy summary of the relative value of these new exchanges, I will instead discuss the broader question of the incremental value of an exchange.
Perhaps the most commonly used metric to assess the value of a venue is trading volume. Using this simple metric, one could argue that there are some exchanges that could fairly be characterized as Peggys. But an academic paper published by three University of Illinois professors provides evidence that even among the most active exchanges, the incremental value of an exchange can vary dramatically[1]. The authors arrive at this conclusion by analyzing two natural experiments involving unexpected technical outages at major equity exchanges. The authors assess how aggregate market quality changes when that venue goes offline, effectively providing a rough measure of the incremental value that venue brings to the broader market.
The first outage the authors investigate involves EDGX outage on July 6, 2015. The authors find that, even though EDGX is a significant exchange in terms of volume, its outage had virtually no impact on aggregate market quality. One explanation is that the lack of impact is due to the ease with which liquidity providers on EDGX can move easily to other venues, thereby resulting in virtually no change in aggregate liquidity. But regardless of the cause, the results suggest that the incremental contribution of EDGX is disproportionately smaller than one may expect given its market volume.
Interestingly, two days later, the New York Stock Exchange experienced a technical outage as well. By being two days apart, the market environment across these two outages were likely similar. But in this case, the authors find the impact of this outage on NYSE-listed stocks was quite dramatic. Specifically, quoted spreads rose over 20% relative to a control group during the outage. And when the NYSE resumed trading, quoted spreads fell back to a more normal level. The reduction in market quality while the NYSE is offline coupled with a return to normal market conditions afterward suggest that the incremental value of the NYSE is substantial. Even more surprising is that the authors attribute this primarily to the unique role the DMM plays in NYSE trading and the lack of fungibility of that liquidity when the NYSE goes offline. Of course, it is hard to disentangle the incremental value of the DMM from the incremental value of the NYSE floor or the unique position the NYSE has as the “primary market” in NYSE-listed stocks. Nevertheless, the disparity in consequence between the NYSE and EDGX outages is quite striking.
Stepping back, the implications here are quite profound, as the results suggests that the incremental value of a venue goes beyond how much volume a venue executes. Rather, the implication is that even some of the larger venues might be adding relatively little (if any!) incremental value to the market more broadly, given the existence of other venues, since apparently the market can do just fine without them.
With that said, these results are based on only two events, both of which were extremely short-term. So, we cannot simply conclude that fewer is better or that volume should be consolidated on a single primary venue, especially if competition across venues results in competitive pressure (e.g., on fees), more innovation, etc. But I believe the biggest takeaway here is that the incremental value of an exchange is not well proxied by trading volume alone. Rather, its what a trading venue actually brings to the party in terms of incremental liquidity, innovative order types, better technology, etc.
The author is the Founder and President of The Bacidore Group, LLC
Footnotes
[1] See “Designated Market Makers Still Matter: Evidence from Two Natural Experiments” by Clark-Joseph, Ye, and Zi, Journal of Financial Economics, 2017.
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