What's an Exchange? PartII: The Real Competitive Advantage-Being an SRO

Equities Exchanges have taken a lot of lumps in recent years, with declining market shares and diminishing respect. But they do have one little-discussed trump card that may ultimately prove their savior:  their own SRO status (and the immunity that comes along with it).

Exchanges have to register as self-regulatory organizations, where each must “enforce compliance by its members, and persons associated with its members, with the federal securities laws and the rules of the exchange.” In return for performing these governmental functions, the SEC has effectively granted them government-like sovereign immunity. As the justifications for exchanges’ immunity have eroded over the past two decades, the consequences for investors--and their competitors--are starting to get pretty steep.

When it permitted exchanges to become profit-oriented firms nearly two decades ago, the SEC effectively opened the door for an entirely new conflict of interest between an exchange’s profit motive and its longstanding SRO responsibilities. For example, would an exchange want to discipline a broker-dealer/member that accounts for a large portion of its revenues or profits? The SEC has never fully addressed this tension. At the time the SEC allowed the switch to for-profit exchanges, it merely stated that there was no “overriding regulatory reason to require exchanges to be not-for-profit membership organizations.”

As for-profit entities, the exchanges and their executives are motivated, and perhaps even obligated, to seek to maximize the value of the enterprises. Most often, this will lead to profit maximization strategies. And exchanges have a number of tools at their disposal to do it. They can charge listing fees, transaction fees, data fees, connectivity fees, and more. They can change their rules and operations in ways that may maximize their profits, such as by creating novel order types or preferences. And while exchanges’ fees and rules are subject to SEC approval, there is little evidence to suggest that the SEC staff has the resources or willingness to meaningfully assess the implications of the five or so they receive each day.

While Nasdaq’s mishandling of the Facebook IPO could have led to a broad rethinking of immunity, it didn’t. Then, on August 26, 2015, a New York judge threw out claims by investors in a far-reaching class action related to high frequency trading. The judge ruled that exchanges are “absolutely immune from suit based on their creation of complex order types and provision of proprietary data feeds, both of which fall within the scope of the quasi-governmental powers delegated to the Exchanges.”

If creating complex order types for traders and selling proprietary data feeds are viewed as “quasi-governmental powers,” and not part of the exchanges’ private for-profit activities, then it seems likely that most activities of the exchanges may fall under this protection. Presumably, this would include, for example, Nasdaq’s controversial new RTFY order type, or NYSE’s new laser connectivity.  Despite the unquestionably profit-based motivation for these activities, it appears as though the exchanges may be immune from any suits arising from them.

But that is not the only conflict-of-interest raised by exchanges’ SRO status. In recent years, the SEC has increasingly relied on the exchanges to develop and implement a number of the SEC’s regulatory initiatives that could have dramatic impacts on the exchanges’ bottom lines.  For example, the exchanges have been tasked with developing the Consolidated Audit Trail. This undertaking is unquestionably a regulatory responsibility. But it will equally unquestionably impact the exchanges’ revenues and profitability. Who will pay for its construction and operation? Will they decide to shift the costs over to broker-dealers and ATSs? How? How will it be governed? The answers to these questions may have dramatic impacts on not only the speed of the CAT project and its ultimate efficacy, but also on the exchanges’ own profitability--and those of their competitors.  

While the conflict-of-interest between exchanges’ SRO responsibilities and their profit-oriented businesses has expanded, the justification for their SRO status has significantly diminished.  

Historically, when trading on a listing exchange served as an effective monopoly over trading in a security, the exchange was well positioned to monitor trading for abuses. That simply isn’t the case anymore. Now, trading is diffused across hundreds of broker-dealer internalizers, dozens of ATSs, and numerous exchanges. It would make little sense for each exchange to conduct surveillance on its venue without input from all other venues. Nor is it practical from a cost perspective for an exchange to develop its own surveillance mechanisms. In fact, cost-conscious exchanges have increasingly outsourced most of their SRO responsibilities to yet another SRO (FINRA). Thus, while exchanges remain responsible for performing oversight, they don’t actually do much themselves.

What does all this mean? To market participants, exchanges and ATSs are largely fungible in all but one way: when they are wronged by an ATS, they can recover from it, but when they are wronged by an exchange, they most likely can’t.

While current SEC Commissioner Stein and former Commissioner Gallagher called on the SEC to reconsider the SRO model well-before the Barclays decision heightened the urgency of that review, we haven’t seen any action yet. The issue does not appear on the SEC regulatory agenda nor does it appear to be anywhere on the radar screen. Maybe it’s time for that to change.