Norges Bank Investment Management, the manager of the $880 billion Government Pension Fund of Norway, issued a new report recently on the role of exchanges in well-functioning markets. Norges argues that “exchanges should remain central to the development and evolution of markets” and suggests that countries with “deep and liquid exchanges” experience superior economic performance. According to the report, over time constraints on exchanges have become less binding – once only members could trade on the exchanges, a lack of technology limited the number of messages that could be processed, and information dissemination was limited both in amount and distance. Despite the potential that exchange could become less central to the market as a result of these changes and increased competition from non-exchange venues, according to Norges, exchanges still hold two advantages– “the policing of listing privileges, and the provision of price discovery.”
The report notes that listing privileges help ensure a level of quality when a company goes public and thus provide a benefit to investors, employees, and the companies themselves. However, it cites a year-over-year decline of 20 percent in the number of listings in the US markets in 2014 and exchange trades notes have comprised a much larger share of those listings. To remedy the decline, Norges suggests that listing requirements may be too stringent and that perhaps smaller companies should receive incentives for going public (such as tax deferrals). It suggests that smaller, regional exchanges may be more beneficial to help smaller companies go public before “graduating” to larger exchanges.
As for price discovery, the report argues that exchanges provide a “utility-like service to all participants in the economy” as a “key arbiter of prices in capital markets.” However, it notes that exchanges are facing increased competition due to market fragmentation and that “[i]ntensified competition amongst exchanges and ATSs poses the threat of a regulatory race to the bottom.” Additionally, the race for speed and bandwidth has “the potential to impose negative externalities on all market participants.” For example, the report identifies the “current latency race as ultimately a dead-end” because additional gains in terms of additional speed improvements are yielding fewer benefits. In other words, “[t]he race to zero is almost over.” Norges argues that those providing the improvements in speed (such as companies installing microwave links between exchanges) extract excessive rent from those using the methods and thus pursuing lower latency is “self-defeating” and will push investors elsewhere as costs rise.
In the wake of these challenges, Norges offers several observations from an asset manager perspective. As markets have evolved, so too has the mix of investors seeking to access those markets. Norges highlights the increasing institutionalization of investing and cites that an average of nearly 80% of outstanding shares is held by institutions as of March 2015 (compared to 50% in 2000). As a result, Norges argues that the market is less comprised of retail and smaller orders that provide continuous matching and that perhaps the central limit order book “may no longer be the optimal mechanism for price discovery in such an environment.” Instead, the rise in popularity of block crossing ability and end of day and intra-day auctions demonstrate that institutions are willing “to give up continuously clearing markets in favour of ‘on-demand’, but more sizeable liquidity events.” The report suggests that, while in the past fixed income markets have looked to equity markets as a model, that model may need to be reversed so that equity markets can learn how concentrated ownership can work in a market.
Norges also argues that exchanges should continue to seek to minimize variable revenue streams (such as per-trade fees) and seek to increase fixed revenue streams (such as data feeds and index businesses). This change in focus will “allow exchanges to focus on the key services they provide to investors and the economy.” In the same vein, the report applauds Nasdaq’s recent experiment in lowering maker/taker fees, and encourages further innovation in the use of batch auctions and different order priority models for exchanges that may emphasize size over time.