The Answer To MEMX

By Kurt Dew:How is MEMX different?

The aptly named Members Exchange LLC (MEMX) is soon (September 4, 2020) to open for business. This exchange distinguishes itself from the Big Three Exchange Management Funds (EMFs) – New York Stock Exchange [NYSE – a subsidiary of Intercontinental Exchange Inc. (ICE)], CBOE Global Markets (CBOE), and NASDAQ Inc. (NDAQ) – by focusing on the needs of its membership, instead of the profitability of its stockholders.

The publicly held EMFs focus on returning exchange profits to ownership. MEMX indicates its intention to distinguish itself from other EMFs by beginning its life as a closely-held firm. Thus, MEMX presumably will focus upon improving the bottom-line results of its membership, in proportion to the member’s capital contribution (see SEC application, page 14). In other words, as with exchanges in days of yore, MEMX's success will depend on its ability to enable member firms to improve their own bottom lines. MEMX is a club whose members will disregard the profitability of MEMX, asking instead whether the exchange has served its purpose.

Why the change from the publicly-held EMFs? Perhaps because MEMX has learned the lesson of BATS Global Markets, an exchange created earlier for the purpose of reducing exchange fees. But because BATS was a for-profit, publicly-held exchange management firm, it was acquired by CBOE in March 2017, apparently to join the other EMFs by matching their higher fees, the value-maximizing thing for an exchange to do. Thus, BATS became just another fee glutton, forcing broker-dealers to add to the lengthening list of exchanges that must be paid full fees regardless of use.

Paul Rowady, of Alphacution Research Conservatory, among others, points to MEMX’s vow to reduce exchange fees, writing for Tabb Forum. MEMX wants to be the last stop on the "Payments for Order Flow" train. To ride the MEMX train, a retail order (read price-insensitive and slow order):

• goes to a retail broker (Charles Schwab Corporation (SCHW), Fidelity Investments, E*TRADE Financial Corp. (ETFC), Robinhood, and TD Ameritrade (AMTD)]. The broker is paid by high-frequency traders (HFTs) for order flow.
• is routed to an HFT [Virtu Financial (VIRT), Citadel, and Jane Street] which pays the exchange for limit orders
• and thence to an exchange.

The missing ingredient in a simple compelling MEMX business model is this. How will MEMX keep its members happy if not through profits?

The inclusion of the major dark pool operators in MEMX ownership [Goldman Sachs (GS), Morgan Stanley (MS), Bank of America ([[BAC]]), JPMorgan Chase & Co. (JPM) and UBS Group AG (UBS)] makes the path to satisfaction of members sufficiently byzantine to open the door for conflict among the firms on MEMX’s board. The addition of BlackRock from the buy-side rounds out the cast of Wall Street players and further muddies the waters of MEMX governance.

But the basic incentive for Wall Street to back MEMX is clear. The broker-dealer community believes it is being soaked by the Big Three exchange management firms. MEMX charges lower fees for data feeds.

But consider the pros and cons of using MEMX because of its lower fees.

• The retail brokers maintain that low fees for order flow are not a factor in the decision to route their orders to one or another HFT. Robinhood, for example, informs its users that

“To ensure we have a fair system, we don’t take rebates into consideration when we choose which market maker will execute your orders.”

• In other words, Robinhood maintains that the only factor it considers is the best bid or offer.
• In turn, the HFTs are not permitted to consider MEMX’s lower fees in placing its orders from retail brokers. FINRA 22 FINRA Rule 5310 (Best Execution and Interpositioning) requires that

“in any transaction for or with a customer or a customer of another broker-dealer, firms use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.”

In other words, every firm that forms a link in the chain from retail customers to market execution appears to be on the hook to ignore fees. But do they? The reality is that HFTs in the retail order execution chain are only committed to improving the Securities Information Processor (SIP) price. According to the Consolidated Tape Association (CTA), this price must

“link the U.S. markets by processing and consolidating all protected bid/ask quotes and trades from every trading venue into a single, easily consumed data feed.”

In other words, the SIP tries to do many things, and in the process the SIP prices get old and slow, making a price that beats the stale SIP price and the fat SIP bid/ask spread – easy pickings for the HFTs. In the current COVID-19 environment, the avalanche of retail orders coupled with greater market volatility has become a land of milk and honey for the HFTs, as the chart above depicts.

Imagine the situation the broker-dealers will face once MEMX opens for business. It seems reasonable to assume that resting orders from market makers will be identical across every exchange at the outset of a trading cycle. Typically, however, the orders at the top of the bid and offer decks are relatively small. Suppose the market maker habit is, quite reasonably, to fall back to larger resting orders when the top of the deck is taken out. This is where MEMX will likely have its opportunity. Broker-dealers can place their orders resting deeper in the deck on any exchange they choose, and MEMX would be the profit-maximizing choice. Thus, during the all-important milliseconds between the trade that takes out the top of the deck to the meat-and-potatoes following order fills, MEMX should gain an advantage from its low fees.

Added to the likelihood that most market orders will be filled by market makers resting deeper in the deck is that retail market orders are likely to be held by the same HFTs. And here is a good reason why MEMX will benefit its members in ways other than simply reducing their fees. MEMX will provide market makers with the ability to bypass the exchanges entirely. Once the retail HFT bids meet the market maker HFT offers, the broker-dealer will benefit both themselves and their customers by filling retail orders in their own dark pools. In other words, MEMX members benefit themselves most by using MEMX quotes to generate in-house profits, leaving the other EMFs out in the cold.

That is an incredibly good question. The big three EMFs, unlike MEMX, must depend on profits to survive. Without trading volume, these EMFs are left naked when the proverbial tide of orders ebbs. Their only remaining source of income is fees for data. The resulting situation – 13 exchanges with no volume, earning fees for data redundant to MEMX quotes – would embarrass the big three EMFs out of existence. MEMX, on the other hand, can continue to roll. No fees. No trades. But a grateful membership.

See also The Early Returns From GEA Group's Turnaround Have Been Very Encouraging on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.