Are Exchanges Casinos?

Joe Saluzzi and I have a cordial relationship.  I am happy for what he has done to expose how various parts of the order flow chain are broken.  Those breaks make the market less competitive and hurt smaller users of the market.  I hope he continues to expose and speak out because frankly, he is articulating an unpopular position that will not curry favor or find him a lot of friends in the industry.

There are many instances where I agree with Joe.  There are points of disagreement as well.

I am an ardent supporter of highly competitive markets.  They provide more value to people who use them and the more competitive they are the cheaper they can provide that value.

• Is the stock market perfectly competitive?  No.
• Has it ever been?  No. The specialist system was full of inequity too.
• Is the futures market perfectly competitive?  No.
• Has the futures market ever been perfectly competitive?  No. Why do you think we paid hundreds of thousands of dollars for a membership?
• Are either marketplaces casinos?  No.  Casinos compete against their customers and always win.  Exchanges don’t compete against their customers.
• Are they rigged?  No.
• Illiquid?  Certainly can be. The Flash Crash is a classic case of illiquidity.  But some markets are very liquid and more liquid than they used to be.
• Manipulated?  Depending on the liquidity they certainly look like they can be.
• Are they fair?  It depends on how you frame fair.  Fairness is arbitrary.

If you are looking to get rich quick, trading is not the place for you to be unless you have computer science, physics, or higher-level math degree.   To be clear, retail stock markets are the place to build wealth.  The way to make money in markets is to invest for the long haul over time.  The majority of people cannot scalp in and out of markets and make a living.  Futures markets are industrial and exist for risk management.  The role of liquidity provider went from highly fragmented individuals to a highly centralized big business automated function.

Let’s think about markets.  They exist in everything.  There are costs and opportunity costs along with scarcity.

One of the dangers in America that I see right now is many different business verticals are dominated by very few companies.  That leads to less innovation.  We only have a few big banks and gutted middle tier and community banking.  How many insurance companies are there?  How about oil companies?  Big tech companies?  You can look at almost any industry vertical and there are very few dominant players at the top.  Some of this is due to the regulatory environment which must change.  I am glad Trump has been on a deregulation tear.

Maybe the academic definition of perfectly competitive markets is exactly that, academic.  But if we start creating a marketplace with that ethos, we can get as close as is humanly possible.  I was always of the opinion that electronic trading marketplaces would be closer to perfectly competitive markets than the old way of doing things which would create more value for participants.

As electronic markets developed, exchange personnel decisions and CFTC/SEC regulations were such that it was impossible to create a perfectly competitive market.   For example, in both markets exchanges have sold out co-location to institutional market participants.  Smaller traders could not afford to pay for the co-location.  It’s a revenue stream for exchanges.  Co-lo leads to institutional traders trading larger volumes which are another revenue stream for exchanges.

You could say, “Exchanges have calculated the costs and opportunity costs of co-location and marginalizing a large group of fragmented traders in favor of highly centralized and institutional traders.”  If you said that, you’d be right and you could argue over the merits and costs of marginalizing an extremely large group of traders.

We need to have an active collegial discussion about marketplaces.  This cannot be couched in fairness because that is an impossible standard.  We need to quantify it down to measurable numbers to show costs and benefits.

I am glad people like Joe have spoken out to uncover things so we can talk about them.