Thoughts on the Evolution of Stock Exchanges

Can stock exchanges adapt to the challenges of today’s capital markets? As “self-regulatory organizations,” U.S. stock exchanges once enjoyed a nearly exclusive role in coordinating information and trading through interwoven regulatory, mutual, and commercial arrangements with public companies, brokers, and dealers. Competitive and regulatory challenges have gradually chipped away at the mystique of self-regulation. While listing in the United States largely remains a duopoly shared by the NYSE and Nasdaq, primary exchanges no longer account for a majority of trading volume in their listed securities. Moreover, even as they continue to play an essential role in setting market prices, their hold over information flows is tenuous. Exchanges have accordingly given up many of their regulatory privileges and responsibilities to compete more nimbly with lightly regulated trading venues.

One former SEC chair thinks the future of exchanges will be fascinating to watch, and possibly painful to endure. As I suggested at a recent symposium at Wake Forest, policymakers must consider whether and how to help exchanges sustain the aura of integrity, liquidity, and efficiency associated with listing and other traditional self-regulatory functions in the face of these trends.

The signaling function of exchanges

An exchange listing historically signaled integrity in corporate governance, a reasonable expectation of liquidity, and public flow of price information. As such, listed securities enjoy both reputational and legal privileges: In the United States, a listing is associated with enhanced price transparency and execution mechanisms, eligibility for margin, derivatives and index trading, and preemption of state securities laws. Exchanges have both a regulatory and commercial imperative to design listing standards that warrant these privileges.

An exchange’s corporate governance standards typically require minimum quorum rules and voting rights, antidilution protections, director independence, certain real-time disclosures, and auditing requirements that exceed the minimum requirements of state corporation law. Top-tier listings ideally boost the reputation of issuers that commit or “bond” to higher corporate governance standards, while dedicated listing tiers for high-tech, startup, or other small- to medium-sized enterprises seek to calibrate the differing needs of issuers and investors in those market tiers.

Exchanges also vie to provide investors with a reasonable expectation of liquidity, commensurate with the market value, trading volume, and diffusion of a listed issuer’s securities. To this end, exchanges designate dealers (known as market makers) to quote prices and trade on a continuous basis. Exchanges also tailor automated systems and trading rules to the needs of retail, institutional and professional investors. To promote efficient price discovery, their disclosure rules and information systems provide assurances as to the immediacy and quality of trading information—for example, by monitoring trading and eliciting additional information when necessary to address imbalances or unusual activity.

Ongoing challenges

Various trends have eroded the once unassailable dominance of stock exchanges. The federalization of corporate governance has diminished the value added by qualitative listing standards. Congress has in some cases displaced listing standards by ratcheting mandatory disclosure and corporate governance rules for public companies across the board. Sarbanes-Oxley and Dodd-Frank reduced flexibility by pressuring or requiring exchanges to adopt specific standards, such as with respect to the autonomy of audit and compensation committees. From a public company’s perspective, the decision to list increasingly looks like a choice among federal corporate governance regimes, rather than a compact with an exchange and its constituencies.

Competition in order execution and listing services has also changed the role of exchanges in managing trading activity and information. Exchanges traditionally maintained dominant market share by restricting trading outside of their facilities and controlling real-time price information. As the SEC pressured exchanges to relax these anticompetitive strictures, trading volume began to migrate to rival trading venues. Meanwhile, the SEC’s policy of promoting decentralized, “intermarket” price discovery and surveillance inadvertently spurred the creation of “dark pools,” which obscure trading interest to confound high-frequency and algorithmic trading strategies. As a result, exchanges face the prospect of losing control over the professional trading activity necessary to guide market prices to an informed equilibrium.

A way forward?

Policymakers are unlikely to let the self-regulatory role of exchanges wither without a fight. The exchanges’ reservoir of reputational capital continues to confer prestige on listed issuers and to attract the participation of retail and institutional investors. More to the point, regulators have hardwired many of their surveillance systems and trading rules to the informational infrastructure maintained by exchanges. The question is not whether exchanges will survive, but how they will compete.

One possibility is that the self-regulatory functions of exchanges—such as listing—will evolve into highly regulated commercial services, like order execution services effectively have. A listing exchange could coordinate liquidity support, research and analysis, and branding for issuers, without the benefit of specific regulatory privileges (much like an investment bank). A transition to pure private ordering may nevertheless benefit larger issuers at the expense of smaller issuers (who may need to subsidize dealers to sustain trading in their securities). Moreover, fragmented trading may reduce the incentive for any one listing exchange to assume the cost of monitoring and promoting informational efficiency.

A second possibility is that a single regulatory authority could assume consolidated responsibility for self-regulatory functions—much like FINRA exclusively regulates public broker-dealers. Macey, O’Hara and Pompilio suggest that an independent self-regulatory body could relieve exchanges of the duty to uphold qualitative and quantitative listing standards by assuming responsibility for delisting. One could push this idea further (as I’ve argued elsewhere) by designating a single listing authority to set minimum corporate governance and liquidity standards for different tiers of retail, margin, derivative and index trading. The downside is the lost potential for diversity in listing standards.

More likely than not, exchanges will follow the model of other professional gatekeepers, such as credit rating agencies. As with credit ratings, an exchange’s determination to include a security in its list will invariably retain evidentiary value for investment allocation, benchmark inclusion, and other prudential considerations. As long as listing boards or agencies can credibly cultivate, certify, and monitor a network of market makers, trading venues, and information systems, listing could remain valuable as an independent signal of investment-worthiness. These relationships—much more so than physical floors, the clattering of the ticker, or the opening bell—represent the heart and soul of exchanges, and policymakers would do well to help exchanges reinforce them.

This post comes to us from Onnig H. Dombalagian, the George Denègre Professor of Law at Tulane Law School and the author of “Chasing the Tape: Information Law and Policy in Capital Markets” (MIT Press, 2015).  The post is based on his recent article, which is entitled “Exchanges, Listless?: The Disintermediation of the Listing Function” and available here.