The SEC Commissioner’s Just So Story That Just Ain’t So

SEC Commissioner Robert J. Jackson is getting a lot of attention for a policy speech he gave at George Mason University last week.  Alas, Commissioner Jackson betrays only a dim understanding of current stock markets and stock market history.  Indeed, perhaps the best summary of his speech would be the Artemis Ward quip: “It ain’t so much the things we don’t know that get us into trouble, it’s the things we do know that just ain’t so.”

Mr. Jackson has a just-so story that, well, just ain’t so.  In his story, once upon a time US stock markets were faithful guardians of the public interest.  Then, the SEC let them become for-profit firms, and it all went wrong:

Given power and a profit motive, even the most storied institutions will do what they must to maximize their wealth. And nowhere has this been more true than in our stock markets.

For over a century, exchanges were collectively owned not-for-profits, overseeing and organizing trading in America’s best-known companies. But about a decade ago, exchanges became private corporations, designed—perhaps even obligated—to maximize profits. Yet we at the SEC have far too often continued to treat the exchanges with the same kid gloves we applied to their not-for-profit ancestors. The result is that, even while one our fundamental mandates is to encourage competition, the SEC has stood on the sidelines while enormous market power has become concentrated in just a few players. That’s a key reason why among our 13 public stock exchanges, 12 are owned by just three corporations. And that’s how the stock exchanges that are a symbol of American capitalism have developed puzzling practices that look nothing like the competitive marketplaces investors deserve.

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First, one might wonder how our stock markets got here. The answer is that stock exchanges have been better at extracting rents than regulators have been at stopping them. As you all know, in 1934, the Nation struck a bargain with our stock exchanges: the Commission was created to oversee the markets, and in turn the exchanges were given wide latitude in organizing their affairs. For generations, this system served investors well. But then the world changed, and the SEC allowed exchanges to become for-profit corporations with both regulatory and profit-seeking mandates.

At the time, the Commission didn’t sufficiently contemplate the effects that decision might have; we simply said that we saw no reason to think that exchanges couldn’t play the role of regulator and pursue profit at the same time. Maybe we were wrong. Whatever one thinks about the benefits or drawbacks of those events, we should all agree that for-profit companies can be counted on to do one thing: pursue profit. And in for-profit hands, SEC oversight designed for not-for-profit exchanges can be dangerous.

Where to begin?

Well, I guess I should begin by saying for probably the billionth time (here’s one of them) that stock markets were not non-profits out of some charitable motive, or to ensure that they acted in the public interest by self-regulating markets free of conflict of interest and mercenary motive.  In fact, stock exchanges (and derivatives exchanges) adopted the not-for-profit form to protect the rents of their members.  Furthermore, the exchanges self-regulated in ways that maximized the profits of their members: it is beyond a joke to say that exchanges are better at extracting rents today than during the halcyon non-profit years.  Non-profit exchanges just extracted rents in different ways, and the rents did not flow through the exchange coffers.  These different ways included naked collusion–which the SEC tolerated for years, kid gloves indeed!–as well as entry restrictions (the number of members remaining fixed since the 19th century) and various rules advantaging intermediaries (especially specialists, but also brokers).

As for conflicts of interest–they were rife in Commissioner Jackson’s good old days.  The exchanges, as agents for their intermediary member-owners, had structural conflicts with the investing public.

Mr. Jackson argues that “modern exchanges tax ordinary investors.”  The implicit claim is that old time exchanges didn’t.  Ha! They just did it in different ways, and arguably levied far greater taxes then than now.

Why were the taxes arguably greater then?  The answer relates to another fundamental error in Jackson’s just so story: “enormous market power has become concentrated in just a few players. That’s a key reason why among our 13 public stock exchanges, 12 are owned by just three corporations.”  Er, prior to RegNMS, a little over a decade ago, and for the entire life of the SEC prior to that time, and prior to the formation of the SEC, the NYSE had a far more dominant position than any exchange does today.  Due to network effects, it basically had a lock on order flow for its listings.  Its market share was routinely above 85 percent, and that other 15 percent was basically cream skimming competition that the SEC only grudgingly accepted.

Again, the NYSE did not capture rents from this market power by charging higher prices and passing the revenues through to owners in the form of dividends.  But through broker cartels, and after the SEC finally bestirred itself to end the broker cartels, through entry limits and rules that advantaged members, it permitted its members to earn rents by charging higher prices for their services.

Indeed, the great benefit of RegNMS is that it undermined the liquidity network effect that largely immunized the NYSE against competition, and unleashed competition for order flow unprecedented in the history of US stock markets–or stock markets anywhere, for that matter.  Three (granting arguendo that 3 rather than 13 is the right number) is a helluva lot more competitive than one.

But Commissioner Jackson cannot see the glass is at least 90 percent full: he frets over the 10 percent (or less) that is empty.  He laments “fragmentation.”

Yes.  As I have written, the “fragmentation” (aka “competition”) that has occurred post-RegNMS has its costs–some of which are the result of problematic features in RegNMS.  Others are inherent in any multi-market system.  Fragmentation creates arbitrage opportunities that some participants capture through spending real resources: this is probably socially wasteful.  Commissioner Jackson notes that these opportunities exist in part due to the lack of incentive of exchanges to invest in the public data feed: well, I’ve noted this public goods problem in the past (note the date–almost 5 years ago).  Yes, some have information advantages due now mainly to speed: well, back in the day, people on the floor had information advantages–and speed advantages–due to their proximity to where price discovery was taking place.  Take it as a law: there will always be a class of traders with information, access and speed advantages over the hoi polloi.

Some of these problems could be remedied by better regulation.  But despite the deficiencies of RegNMS, there is no doubt that it made US equity markets far more competitive, and that this has redounded to the benefit of ordinary investors–and pretty much the entire buy side, including institutions.  RegNMS dramatically reduced the “tax” that stock markets levied on investors, not increased it as Mr. Jackson apparently believes.

Commissioner Jackson questions whether the limited exposure to lawsuits that exchanges currently enjoy is justified.  That is a legitimate question, but Mr. Jackson’s motivation for asking it is completely off-base.  His fixation on for-profit again shines through: “Finally, we should take a hard look at whether it makes sense to allow for-profit exchanges to write the rules of the game for their customers and competitors while also enjoying immunity from civil liability.”  Mr. Jackson: it is equally questionable whether it makes sense “to allow non-profit exchanges to write the rules of the game for their customers and competitors while also enjoying immunity from civil liability.”

Commissioner Jackson also questions pricing practices: “Finally, SEC and FINRA rules for best execution have clearly left open opportunities for conflicts of interest that hurt investors. The reason is that exchanges offer controversial payments—they call them rebates—to brokers based on the volume of customer orders that broker sends to that exchange.”  This is a form of price competition.  Yes, there are agency issues involved here, but if anything these rebates reduce the rents that exchanges earn that exercise Commissioner Jackson so greatly.  Perhaps brokers don’t pass 100 percent of the rebates to their customers–but this is a distributive issue not an efficiency one, and competition between brokers mitigates this problem.

Perhaps in the category of “rebates” Commissioner Jackson is including maker-taker payments. But the interpretation of these payments–and the more prosaic order flow incentives Mr. Jackson describes–is greatly complicated by the fact that exchanges are multi-sided platforms.  It is well-known that the pricing policies of multi-sided platforms often involve cross-subsidies among customer groups (e.g., liquidity suppliers and liquidity demanders), and that these pricing strategies can be economically efficient.

US securities market structure could certainly be improved.  But reasonable improvements must be grounded in a reasonable understanding of the economics of exchanges.  Alas, one individual responsible for improving market structure is clearly operating from a seriously defective understanding. Commissioner Jackson’s bugbear–for-profit exchanges–have to a first approximation nothing to do with whatever ails US markets.  He pines for an era that not only never existed, but which was in reality worse on almost every dimension that he criticizes modern markets for–competition, rent seeking, and conflicts of interest.

The SEC actually performed a public service–something not to be taken for granted for a public agency!–by breaking the liquidity network effect and opening stock markets to competition through the adoption of RegNMS.  Tweak RegNMS to improve market performance, Commissioner Jackson, rather than advocating proposals based on just so stories that just ain’t–and weren’t–so.