Rob Daly: Bring Back the Regionals

I’m tired of discussing which exchange will wind up with which. I’d say the odds that the London Stock Exchange Group will wind up purchasing TMX Group stand at about 60–40. As for NYSE Euronext, I have a strong feeling that it will be carved up between Nasdaq OMX and the IntercontinentalExchange (ICE), based on the premium the two US-based exchanges are offering NYSE Euronext shareholders compared to the earlier deal proposed by Deutsche Börse.

Yet I’m wondering how necessary this latest round of consolidation truly is. Just because exchange operators can consolidate, should they? Regulators have always been proponents of exchange competition, arguing that it is best for the investors since it spurs innovation and lowers prices. But does the world want competition between only three or four exchange operators?

It’s too late to bring back the American Stock Exchange, the Boston Stock Exchange or the Pacific Stock Exchange as free-standing organizations, but the role of regional stock exchanges should not be underestimated.

Local Demand
Regional stock exchanges sprung up because there was a local demand to support them. As trading went electronic and the New York- and Chicago-based exchange operators started buying up their smaller regional siblings, trading left New England and the West Coast and moved to Chicago and Northern New Jersey. Most of the über-exchange operators have adopted the same business model of running multiple protected quotes from the same datacenters and differentiating the prices from each market with a different rebate model. It’s efficient and works for now, but this geographic centralization of trading centers has pushed the issue of latency and co-location to the fore. Not only are latency-arbitrage firms looking to co-locate, but the general run-of-the-mill traders located far from exchanges also need to co-locate their servers within an exchange’s datacenters.

Imagine if one of these large exchange operators decided to geographically divide its matching engines to improve latency performance for its remote traders. Would a West Coast exchange be such a crazy idea? Consider that under current Regulation NMS rules, it could easily capture the local liquidity from California, Washington and Oregon as well as a good portion of the Asia-Pacific traffic coming to North America. Also, it would be closer to the Canadian energy markets than New Jersey.

And it doesn’t necessarily need to be a West Coast exchange. A new exchange located in Texas could also offer lower latency for West Coast traders as well as those in Mexico and the rest of Latin America. This concept of “geo-latency” is not a new one. Academics from the Massachusetts Institute of Technology (MIT) have been researching the optimal global network location to place trading nodes in order to connect to 52 global exchanges. This idea, however, brings the mountain to Mohammed.

Multiple Medallions
Most of the largest exchanges already have multiple exchange medallions and it would be much easier for them to either re-purpose an existing one or request yet another from the US Securities and Exchange Commission (SEC). It’s doubtful that a newcomer would be able to pull off such a business coup without the larger competitor jumping into the fray, but there just might be another Bats Global Trading or Direct Edge waiting in the wings.

In any case, it’s time to start envisioning market fragmentation from a geographic as well as a business perspective. To better serve the market and level the trading field, exchange operators should look to move some of their matching engines out of their current centralized datacenterss and stake ground in some large and underserved markets.