To set the rules

Why banks, hedge funds and Silicon Valley all want their own stock exchanges

April 1, 2014
April 1, 2014

Because market makers are profit takers.

The new book from financial scribe Michael Lewis tracks the battle over high-frequency trading, computer-augmented strategies traders use to exploit small differences in time and price. Lewis argues that such strategies “very likely generated more billions of dollars a year than the other strategies combined.”

Those billions come from out of many different pockets, but mostly from the those who buy the most stock: Big institutional investors that manage most individual investors’ money, hedge funds, and the offices who manage the fortunes of wealthy families.

But things could be changing. The excerpt of the Michael Lewis book, published yesterday, focuses on the creation of a new stock exchange, IEX, that is designed to foil high-speed traders. Much of the same story was published here after IEX opened last fall. What Lewis brings to the story now, besides his narrative touch, is the knowledge that since IEX launched, major Wall Street financial institutions ignored their clients’ instructions to use it for their orders and campaigned against it.

One of them said: “When we told them we wanted to route to IEX, they said: ‘Why would you want that? We can’t do that!’ ” After the first six weeks of IEX’s life, a big Wall Street bank inadvertently disclosed to one big investor that it hadn’t routed a single order to IEX — despite explicit directions from the investor to do so. Another big mutual fund manager estimated that when he told the big banks to route to IEX, they had done so “at most 10 percent of the time.”

All this despite figures from IEX that show customers buying stocks there get a fairer price. Of course, there’s long been a conflict between Wall Street and the various investors it ostensibly exists to serve. As investment manager Josh Brown notes, the sell-side—banks who serve as the middle men of the financial system—has been trying to rig markets in its favor since at least 1792. IEX, built by buyers, is built to favor buyers.

Perhaps no other constituency is more frustrated with the way Wall Street operates than entrepreneurs and investors in Silicon Valley. They’ve been vocal about their beliefs that current equity market structure actually hinders the long-term development of companies because they are so dominated by  high-frequency trading, short-selling, and quarterly investor pressures. In the past, Silicon Valley heavyweights have even mused about starting alternative stock exchanges themselves over the next decade or so.

The arrival of IEX might mean that change could be coming much faster. While companies can’t go public on IEX (yet), it will be interesting to see if large tech firms ask their bankers to rely more on IEX or if venture funds start preferring the exchange for their public transactions.

But a Silicon Valley exchange would have its own unique wrinkles: It would likely make it easier for companies to insulate founders from shareholder pressure, like the dual-class structure adopted by Mark Zuckerberg’s Facebook, or rules to make IPOs cheaper.

That could be a good thing: Few people will defend the obsession with quarterly earnings as particularly beneficial. But if your market isn’t built by other buyers, beware the unintended consequences of its rules.

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