To Start a Revolution, the Small Exchange Needs Revolutionaries

John Lothian

John Lothian

Executive Chairman and CEO

An Old Idea to Start a New Revolution

In a recent JLN interview, Donnie Roberts, the CEO of the Small Exchange, said he “want(ed) people to join a bit of a revolution that we feel we have started.” If Roberts is going to succeed, he is going to have to put on his Phrygian cap and start a real revolution. 

Luckily for him, there is a revolution in retail trading happening right now. 

One of the elements that has propelled the Small Exchange to its early success is also the thing that could hold it back from a revolution. That element is its strategic owners, who have strong ties to the dominant exchanges. Small Exchange’s strategic investors, like Citadel Securities, PEAK6, Jump Trading, IBKR and Phillip Capital, need to balance their revolutionary zeal with their much larger business interests in the dominant exchanges, e.g., CME Group and Intercontinental Exchange.

What the Small Exchange needs for its new investors is a Green Bay Packers-like approach, where their small customers hold the dominant equity interest in the exchange. The Small Exchange needs its true owners to be the small customers who now trade and will trade on their exchange. Right now, about 60% of its volume is from  retail traders and 40% is from market makers, Roberts told me in a video interview.

A friend of mine commented on my Small Exchange interview with Roberts that the exchange was just making more money for the rich market makers. The market makers are taking the other side of the orders and profiting from their equity interests in the exchange, he said. Or put another way, the market makers are getting the mine and the small traders are getting the shaft.

Of course, the Small Exchange is not yet making money, so the payoff from the equity interest has yet to be realized. 

In an era of crowdfunding, the Small Exchange could find a large group of small investors to own shares in the exchange. In the era of the rise of retail traders’ zeal to revolutionize the markets, this is a chance for them to actualize Roberts’ revolution.

The Small Exchange is the right idea at the right time, as evidenced by the huge success the existing exchanges have seen adopting small- or micro-sized contracts. The Micro E-Mini S&P contract of the CME Group was the most successful product launch in the history of the markets. But they have an uphill battle to fight, Roberts admitted. To win that battle they are going to have to be different, from head to toe of the organization. 

One thing about being in a battle, you have to get into some fights. An underdog like the Small Exchange needs to pick some fights, and you need the backing of your board and owners when doing so.

Ownership of the exchange matters. Owners with conflicting allegiances are unlikely to be part of a revolution. In fact, the conflicts of market players can make competition quite a joke. I remember moderating a panel for a business group in Chicago with representatives from the CME, CBOT, LIFFE and another party. Because the CBOT was clearing the CME, the CBOT rep had very little to say about the CME. Because the CBOT rep was using LIFFE Connect as an electronic trading platform, the CBOT rep had little to say about LIFFE. And vice visa versa all the way around. It was a love fest among competitors who lacked the audacity to be competitors. 

Ownership matters. Who your owners are matters. Who is on your board matters. The Small Exchange needs revolutionary owners if they are going to really lead a revolution. 

Who is the Small Exchange leading the revolution for?  It is not leading it for the market makers. It is  not leading it for the brokers.  It is leading it for the small traders, the small investors. So their owners should be the small investors and traders. 

Several years ago, before the Small Exchange was a twinkle in the eyes of Roberts and Tom Sosnoff, I wrote a commentary about what a new start up exchange should do to level the playing field between the professional traders using high-frequency trading and the small retail investors.

In my theoretical exchange, I had a fee structure that attempted to limit professional participation in the market for the benefit of the smaller trader. The idea was to limit the percentage of trading a firm could do on the exchange on any given day. If the firm participated in a larger percentage of the exchange total volume, their fees would double or triple, depending upon the percentage. If 10% was the base level and a firm jumped to 20% of the exchange volume, then their fees would double. If there is greater opportunity in the market — enough to encourage a market-making firm to double its percentage of trading volume — the exchange and its owners should participate in that.

My speed bump for the professional traders was to make them pay more for trading more. If the opportunity was so great, then they should pay more to participate in it. 

Additionally, fees for retail traders were free. The small trader is at a disadvantage in the markets to the highly financed, technologically advanced professional traders. Heck, today some professional traders are using artificial intelligence to help them make trading decisions, while retail traders are using the seat of their pants. While retail traders have more trading tools at their fingertips than ever before, they are still outgunned by the pros. 

I am not sure that you can ever truly level the playing field. But you can tilt it a little to help the small retail trader have a greater chance at success. Professional traders on the trading floor had an edge, so giving one group of traders an edge is not a new concept.

Small traders are essential for the health of the market ecosystem. Small traders are the food that feeds the medium and large traders in the ecosystems. And they are the leading indicator for the market. They help make price discovery work. 

But the real issue here is a lack of diversity of market participants in the professional ranks. As Professor Donald MacKenzie notes in his upcoming book on high-frequency trading, there has been huge consolidation in the principal trader ranks. Many significant players have been closed or bought up by the surviving dominant market makers, the Citadel Securities, PEAK6s, DRWs and Jump Tradings of the world. 

We need the diversification of ideas the retail traders bring. We need an exchange that is putting the interests of the small traders first, second and third. 

What I am proposing is not completely revolutionary. In fact, what I am proposing was the dominant way that exchanges existed before demutualizing and going public in the 2000s. Member opportunity was the focus of the CBOT, CME, NYSE and others when their individual members owned them. 

The Small Exchange should find a way to attract small traders for their exchange that also want to be Small Exchange investors. Make the dominant economic interest of the exchange offering the small trader a place to trade and invest, including in the exchange itself. 

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