In the midst of the high frequency trading debate, many are also decrying the for profit exchanges model. However, for profit exchanges had nothing to do with the advent of HFT. HFT would have been here with or without them.
There was a reason for exchanges to go for profit. They were going broke being mutually held. When an operation is run at break even, it loses money. Exchanges had to make gigantic investments in technology if they were going to maintain relevancy. If exchanges hadn’t gone for profit, the ones you know so well today would be relegated to the dust bin of history.
I was an early advocate at the CME of going for profit. We were a mutually held organization. I was a member of the CME Board of Directors when we switched over. It took from 1998 to 2001 to actually do all that was necessary to change the direction of the exchange. Members voted to change it. The members of that board voted to have run off elections to shrink the size of the board, from 40 to 19 people, in preparation of becoming a public company.
All that being said, I don’t think exchanges are perfect. There is a lot wrong with our marketplaces, but it doesn’t start at the exchange level. It starts at the regulatory level. Exchanges have lost touch with many of their constituencies, and don’t have the same market savvy they once did. They have lost their focus at providing a level playing field and a good market in the name of greater volume. But, their existing structure is still better than their prior non-profit mutual structure.
To give you some idea of how exchanges functioned before being public and for profit, I will try to illustrate a couple examples.
Exchanges had membership structures. The CME had over 230 standing committees staffed by the membership that oversaw the executive staff of the exchange. Members had to approve everything at a committee level, then a board level to get things done. The easiest way to think about it is to use the metaphor of government. Elected officials oversee the bureaucracy. Same at an exchange. I was elected by my fellow members to run the place, along with 39 other board members. Different divisions, products, and of course, constituencies.
Because of IRS tax rulings, there is still a remnant of the member structure left at many exchanges. You can still lease a seat and save money on fees. But management runs the place, not the members.
If you think that members worried only about fair markets, you are seriously mistaken. They worried about their pocketbooks every bit as much as anyone else would and exchange politics could be brutal. Exchanges were seriously bureaucratic.
One of the committees I was co-chair of was the Headset Committee. We oversaw where people could use headsets, and how much the exchange would charge for them. It was a huge battle at the time. There was no computerization. Customers wanted to put headsets on their brokers in the pit and talk to them directly. Locals were against this, because it meant that customers would have equal access to the order flow of the pit. Does this sound like a co-location argument? However, locals that owned their memberships in the pit had a legit beef. They spent hundreds of thousands of dollars to become a member to have access to that order flow. The outside customer didn’t. The compromise was to let clerks on the side of the pit wear a headset. Given all the circumstances, and economics, it was a good compromise.
Of course, we had to figure out how much to charge for this convenience. As a member of the board, knowing we were going to go for profit, I wondered what the break even price was. It was $120/month. So, I suggested we charge more, like $140/mo and make a little money! However, there was a political constituency in another market that said if we raised the price it would dent their profitability. So, we hashed it out. It took some time, and we finally settled on the break even price. Even that was debated at the board level, because there were board members against giving anyone a headset, and some that wanted them provided for cheaper than break even.
Do you really want that structure today? I don’t think so.
Virtually everything the exchange did became sort of controversial. I felt for some fellow board members that were in charge of redesigning pits. Every square inch of a pit was battled for. If a step was two or four inches higher than another, you could guarantee a fight. When we argued over the Eurodollar($GE_F) roll over, it was a fight every time. Innovative ideas were often quashed in favor of the older methods.
Do you think those idiosyncracies would change if it was a mutual organization given today’s trading environment?
I don’t agree with a lot of things the exchanges do. In many cases, I think that I am correct. It’s easy for me to take some potshots at them from outside the arena. I don’t have the same amount of information that they do, and I do the best I can. I don’t think co-location is done properly, because it gives an ultimate edge to one segment of the market. Exchanges should make things flat. That was one of the reasons for converting, to take it out of the hands of the members and put it into the hands of decision makers that would do things in the best interest of the market. Instead, they are doing what good employees of corporations do and making decisions in the best interest of profits for the exchange.
That’s not bad or good, it’s human.
But I think that we all agree that exchanges being for profit are much better than exchanges being run by members. If the trading community and the regulators mandate that we go back to the way it was, I will be happy since I own some seats. If that happens, seats are dirt cheap.