As stock market officials sound the alarm about rattled investor confidence in the wake of the botched Facebook initial public offering last month, some traders and other market experts say there's a basic problem contributing to the crisis: too many exchanges.
"There's increasing competition over a smaller and smaller market," said David Weild, former vice chairman of Nasdaq and now chairman of Capital Markets Advisory Partners, an investment advisory firm. "You just don't have the stock trading volumes to support" them all, he said.
The pursuit of fresh volume is leading exchanges to court business from riskier traders, the experts contend, which is bad news for average investors.
According to data provided by financial research and advisory firm Tabb Group, there are now 71 venues in which stocks are traded in the United States. These include 13 traditional exchanges (among them, well-known venues like the New York Stock Exchange and Nasdaq, and lesser known ones like BATS and NYSE Arca) and 19 "dark pools" (which are closed to the general investing public). The rise of new trading places has taken market share away from the traditional exchanges, according to figures from Tabb Group. The New York Stock Exchange, for example, is down about 37 percent in market share from 2008. At the same time, stock trading volume in the U.S. is cratering -- down 23 percent from 2008, according to research from investment banking firm and institutional brokerage Sandler O'Neil.
"It's a tremendously cutthroat environment for exchanges," said Tabb Group founder Larry Tabb. "Volume is off 40 percent. Confidence is not doing particularly well."
This toxic combination of new competition and lackluster trading is directly related to the steady dive in market confidence, according to David Frenk, research director at market reform advocacy group Better Markets. "Because there's so much competition among exchanges, the exchanges are incented to look for [ways to increase trading] volume," Frenk said. "And who's providing the volume? It's high-frequency traders."
High-frequency trading has come under close scrutiny in recent months. Critics contend that the high-speed, computerized purchase and sale of stocks, bonds and derivatives can distort prices and lead to market instability that spooks average investors -- such as a May 2010 plunge, later dubbed the "flash crash," in which the Dow Jones Industrial Average tanked by 1,000 points in a matter of minutes.
"The implications of high-frequency traders for mom-and-pop investors are very bad," said Frenk.
Exchange competition serves high-frequency traders because they can exploit minute differences in stock listing prices among the different exchanges, said Joseph Saluzzi, co-founder of institutional brokerage firm Themis Trading who has written about market fragmentation in a recent book titled "Broken Markets."
"Why do we need 13 stock exchanges?" Saluzzi asked, suggesting that 13 is already an excessive number of exchanges. It "creates arbitrage opportunities that shouldn't even exist. When [a high-frequency trader] can trade in a microsecond because there is a price discrepancy between exchanges, that [does not] help investors."
Even exchange executives acknowledge that competition has never been fiercer. "It's the understatement of the year to say that exchange competition is at an all-time high," said Bryan Harkins, chief operating officer of electronic stock exchange Direct Edge, one of the largest exchanges in the country behind the New York Stock Exchange and Nasdaq.
But Harkins argues that ultimately the competition is good for investors because it brings down trading costs and spurs innovation. "When competition is high, there's a never-ending rate war," which, he said, "brings out more tools and a better product for investors."
The critics respond that high competition and low trading volumes fuel a vicious cycle. As exchanges increasingly cater to high-frequency traders, average investors flee -- which in turn makes the exchanges more dependent on the volume that high-frequency traders provide.
"The problem is exchanges make the money from [trading] volume," said Frenk. "High-frequency trading volume is lucrative to exchanges but drives away retail and institutional investors. That leaves the exchanges with a gap to fill. So what is the end game -- the equity markets end up a casino with bets being placed with different high-speed computers?"
Because of these conditions, "we've entered a totally new terrain undermining investor confidence en masse," said Weild.
What's the solution? Frenk said regulation of high-frequency trading would gradually increase investor confidence. The Securities and Exchange Commission and the Commodity Futures Trading Commission "should take a look at these traders and find out what mechanisms are causing" problems, he said.
Saluzzi argues for a different approach. Ideally, he said, stock exchanges would operate like public utilities, not for-profit companies. This would eliminate some of the incentive to continually seek more trading volume at the expense of average investors. But, he acknowledged, this change is unlikely, at least in the short term: "You can't force a company to be not-for-profit."
So Saluzzi calls for a more immediate solution. The government should "stop approving new exchanges that don't offer an innovation," he said. "That's the first thing you can do."
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