Why monopolies may be positive for exchanges

I review Walter Mattli's book, "Darkness by Design," in the latest issue of Foreign Affairs and he has a provocative yet compelling thesis.

What he's saying: He believes the U.S. stock market was much better regulated before 2005, in the years when the New York Stock Exchange had monopoly power and self-regulation had teeth.

By the numbers: Since then, the number of exchanges has risen to 23; NYSE market share has dropped to 12%; and the NYSE no longer has the ability or inclination to police the entire market.

• Without the NYSE keeping a watchful eye on trading, the entire stock market has been overrun by predatory high-frequency traders. Far from enforcing a level playing field, the exchanges are incentivized to give the HFTs every conceivable advantage. The algobots provide most of the exchanges' volume and liquidity, after all.
• The losers: Big institutional investors, accounting for the lion's share of the money that Americans have invested in the stock market, are the biggest losers. No one exchange has sufficient liquidity any more to absorb large trades, which are the only trades that big investors really want to do.
• The winners: Individual retail investors probably come out on top from this deal, but it's the high-frequency traders who are by far the biggest winners. Even on the rare occasions that they are caught in unlawful exploits, they generally suffer de minimis consequences. The occasional fine does them no reputational damage, and pales in comparison to the profits they can make.

Exchanges matter. Exhibit A: In the end, it was the Chicago Mercantile Exchange that dealt the final death blow to the theory, published in Vanity Fair, alleging President Trump or his associates had somehow been trading major geopolitical news by buying and selling e-mini contracts on the futures markets.

• Impartial observers, including myself and futures expert George Pearkes, poured cold water on the theory as soon as it came out. But journalists sniping at one another rarely settles anything.
• The CME press release settled everything. "CME Group regularly monitors its markets for suspicious activity," it said. "As it relates to the Vanity Fair article published on October 17, 2019, regarding activities in the E-mini S&P 500 futures contract, the allegations about the trading activity are patently false."
• CME would know, because it has a monopoly on e-mini trading. There are various e-mini contracts, but all of them are traded only on the CME.

The big picture: The CME, host to trillions of dollars' worth of trades, needs to be trusted by thousands of counterparties around the world.

• As such, it's in the exchange's own best interest to ensure that, in the words of the Vanity Fair headline, no "hanky-panky" is going on. It's CME itself, rather than any regulator, that's best placed to do so.
• Regulators can't hope to keep up with the volume and sophistication of these markets. Only the exchanges themselves have the wherewithal to track every trade and ensure there are no shenanigans.

The bottom line: While the CME, with its monopoly, does a good job of staying on top of the e-mini contract in particular, it can't effectively regulate today's ultra-sophisticated cross-border arbitrageurs.

• In order to do that, it would need to merge with stock and futures exchanges around the world.
• That would violate any number of global antitrust laws, but it might be less bad than the status quo.

Finally, you might be interested in what William Cohan, the author of the Vanity Fair story, is saying in the wake of the CME statement. He pointed me his comments to Vox, which basically boils down to, "I was merely asking questions."

• He also said that regulators should examine the trades, without specifying which regulators, or how they would be better placed to do such an examination than the CME itself.