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Curatia Analysis for Mon, Apr 22

Can New Exchanges Break Through?

Growing industry dissatisfaction with incumbent exchanges has prompted a profusion of new exchange launches aimed at meaningful market structure reform.

But such projects have frequently met with regulatory resistance or struggled to establish a defensible competitive advantage, raising the prospect of undifferentiated competition that could undermine investors’ interests by fragmenting markets.

LTSE

The Long-Term Stock Exchange (LTSE) has run into significant headwinds in its bid to incentivize long-term thinking among shareholders. In a setback to LTSE, IEX terminated its listings partnership with the would-be exchange last August.

In January, the Council of Institutional Investors questioned whether rewarding long-term shareholders with additional voting rights would “‘disproportionately empower’” corporate executives — already an emergent critique of dual-class equity structures increasingly popular with tech companies. Investors also fret over the administrative burdens of more nuanced corporate governance provisos.

LTSE has so far struggled to quell those concerns with specific proposals to undergird its broader vision. In November, it submitted an exchange application devoid of long-term ownership incentives as it seeks to gain fast-track approval from the SEC by July.

But the strategy leaves industry participants confused about how LTSE plans to differentiate itself — and, as a result, less likely to support the initiative.

MIAX

Miami International faces a similar challenge. After tripling its share of the stock-options market in five years, the upstart aims to launch a low-cost equities exchange (MIAX) this year.

Industry participants wary of the fixed costs of establishing mandatory connections to every stock exchange have greeted the move with skepticism. “‘More fragmentation is not good if it doesn’t bring any truly new innovations or savings to the marketplace,’” Aite Group technology analyst Spencer Mindlin said.

Incumbent Exchange Strategy

Incumbent exchanges have seized on concerns over market fragmentation to argue against exchange proliferation. Those contentions factored into a lengthy SEC delay in approving IEX’s exchange application in 2017, for example.

Moreover, they form one half of a phased resist-and-replicate strategy incumbent exchanges have honed over time. NYSE, Nasdaq, and Cboe, once vociferous opponents of IEX’s speed bump, are now all deploying or contemplating speed bumps of their own.

Incumbents’ strategy of preempting upstarts through replication extends beyond the equities realm.

After The Small Exchange announced its intention to build a new futures trading ecosystem catering to retail traders with a launch targeted for Q3, CME quickly counterpunched by launching retail-friendly Micro E-Mini Equity Index Futures contracts linked to key indices that are 1/10 the size of its market-standard flagship E-Mini products.

Incumbent exchanges’ tactic of resorting to replication lends credence to their arguments about needless fragmentation owing to growing competition without real differentiation. In addition, it makes upstarts loathe to detail their plans prematurely for fear of squandering their first-mover advantage.

That decreased transparency can temper industry support for new exchanges as participants weigh a murky menu of benefits against the increased fixed cost of exchange connectivity.

Economic cyclicality also factors into the equation. Upstarts whose exchange applications are delayed or whose market share remains constrained by incumbent replication risk falling prey to the privations of a market downturn before they’ve established themselves. Incumbents are almost certainly aware of those dynamics and willing to leverage them.

For players like the Members Exchange (MEMX), the key to success will be to solve the Riddle of Differentiation in a way that defies incumbents’ resist-and-replicate strategy — the most difficult order of all to fill.