Last week’s announcement of a new venue for trading US stocks backed by a consortium of financial firms has industry participants excited about the prospect of lower fees, but experts say critical elements of the plan remain unclear, and warn that the participants will need to overcome competitive differences before they can truly benefit from their investments in the project.

A group of nine sell-side and buy-side firms announced on January 7 that they would file an application with US regulators to establish a new exchange—named Members Exchange (MEMX). Its aim: to “simplify the execution of equity trading in the US.”

Based in New York, its founding members include some of the largest retail broker-dealers and institutional market-makers in US equity markets: Bank of America Merrill Lynch, Charles Schwab, Citadel Securities, E*Trade, Fidelity Investments, Morgan Stanley, UBS, TD Ameritrade, and Virtu Financial.

However, while MEMX may have built-in liquidity at the start—depending on the commitments of those firms, competing with incumbent exchanges such as Nasdaq, Cboe and the New York Stock Exchange, whose technology and markets dominate stock trading in the US—will be a tough task.

In addition, starting an exchange group is more than simply building a matching engine.

“You need clients. You need general rules of the road. You need the tech infrastructure to service your clients. You need the back-office functionality to keep track of assets and reconcile,” says John Lin, CEO of proprietary trading firm Grasshopper. “Here is the question: If MEMX succeeds, will it just displace the current status quo with their own, and will the new status quo be more open, or less open to all market participants? Key elements of such a tight member group would probably always be averse to truly open competition.”

Nature of the Game

From a technical perspective, the gradient of the hill that MEMX may have to climb depends on what segments of the market it will cater for. In this, the incumbents undoubtedly have an advantage—NYSE rolled out its modernized trading platform, Pillar, in 2016, while Nasdaq has been pursuing a unified technology program, the Financial Framework, for several years now. Cboe, likewise, has benefited technologically from its 2017 acquisition of Bats Global Markets, and is waist-deep in a program to transition its options markets to the new technology.

Equity trading, in particular, is a technologically intensive operation in modern markets. Exchanges such as NYSE and Nasdaq offer matching engines with microsecond-level latency, co-location in datacenters, and ultra-fast market data connections for the most sophisticated trading outfits, which include MEMX co-founders Citadel Securities and Virtu.

“You don’t just build that level of sophistication up overnight,” says a source close to the incumbent exchanges’ thinking. “This has been a years-long, and sometimes decades-long project to modernize American markets, and you can’t just buy this stuff off the shelf or whip it up in a few months.”

Much of that infrastructure exists specifically to support the complexity of equity markets in terms of managing retail flow, order types and various other concessions to a market structure that has, in many ways, become fragmented by technological capability. Here, some say, MEMX may actually have an advantage: Its statements make it clear that it is pursuing a limited number of order types—the unfettered proliferation of which has long been a bugbear of market-structure critics—and that it will not seek to implement “speed bumps.”

If that is the case, then MEMX’s members may be able to use their existing order-routing expertise to build the bones of the new exchange. Most of the firms investing in MEMX already operate exchange-like technology stacks to run their dark pools and systematic internalizers, which have taken over from the old broker crossing networks in Europe with the advent of the revised Markets in Financial Instruments Directive.

“I don’t think it’s that complicated. Most brokers will have a dark pool or a matching engine that could be tweaked to offer this type of functionality depending on the structure,” says a managing director at an Asia-based institutional broker-dealer. “Instead of a dark pool being dark, you would disseminate the pricing information.”

In a dark pool or internalizer, that information is currently disseminated to the firm’s smart order-router. The managing director says that changing that dissemination to a third-party data distribution platform would not be an enormous technical hurdle.

Others are more hesitant to dismiss the challenge of adapting the technology. While dark-pool technology is generally “just a derivative of normal exchange technology,” says Grasshopper’s Lin, most are designed to handle far lower volumes and throughput than an exchange’s matching engine, and are “perhaps not the most robust platforms.”

Likewise, the exchange source says the process of adapting broker platforms is “a little more complicated than that.”

Cost Control

One of MEMX’s founding pillars is the promise of low fees for participants. Indeed, the issue of cost is inextricably linked to the creation of MEMX.

2018 saw a fierce debate between exchanges, trading firms, and regulators around the fees charged by exchanges for data products. This culminated in an October action by the US Securities and Exchange Commission (SEC), which struck down two long-disputed fee proposals by the NYSE and Nasdaq.

If discontent over the costs associated with modern exchanges is the root cause of industry malaise, however, MEMX is a visible manifestation of its effects. Some say that while incumbents may not be overly concerned about the threat to their businesses from MEMX, they should nevertheless consider it a warning, insofar as the emergence of the consortium shows the debate is moving beyond gripes and penny pinching, and evolving into something more serious.

“I don’t believe for a second that, you know, [Nasdaq and NYSE presidents] Adena Friedman or Stacey Cunningham are shaking in their boots. Not at all,” says Bruce Fador, managing partner at Fador Consulting Group. “If I’m them, I’m saying ‘OK, how do we have a conversation with this group [of firms]? Putting MEMX aside as a business, let’s have a conversation with them and ask: What do you want to do? What are you ultimately trying to accomplish?’ It would cause me to say I’ve obviously not listened to you effectively as my customer.”

That outcome may be a painful pill for exchanges to swallow—on the day that the consortium was announced, the World Federation of Exchanges issued a press release outlining the reasons why exchanges charge the fees they do for data products—but may ultimately be the optimal result for MEMX.

After all, this is not the first time that upstart exchanges have tried to wrest control from the incumbents. Take, for example, New York-based IEX, which launched in 2016 amid much fanfare, having been helped enormously by its profile in Michael Lewis’ book, Flash Boys. While much has been written about the startup exchange, it has struggled to gain traction among market participants, with its month-to-date volumes reaching 2.72 percent of the US market at the time of this writing, according to market data from Cboe, and its plans for a listings business still yet to be realized.

Likewise, the industry has a patchy history when it comes to ownership of trading venues and technologies that have a stated aim of disruption, with the theme of member ownership being something of a cyclical issue. Examples include OptiMark, a trading system built in the late 1990s that was devised by brokers and institutional traders to challenge Bloomberg, but which was eventually incorporated by Nasdaq. Chi-X was another example of industry ownership of an exchange group—which was eventually sold to Bats.

The Kansas City-based operator also picked up another nascent exchange group that had grown up under the wings of trading firms—some of whom are represented in MEMX’s ownership—in the form of Direct Edge. Ironically, Bats itself would later be acquired by Cboe, creating the very power player that MEMX is seeking to challenge.

“It’s not that these things don’t have good objectives, but to accomplish this stuff is really difficult because our industry doesn’t move quickly,” says Fador. “I mean, it really doesn’t. There’s a portion of it that embraces change, but it’s only a small portion.”

Competing Interests

Many details about MEMX remain unclear. The exchange is still in an embryonic phase, and key questions around its technology and purpose remain unanswered.

“The biggest hurdle will be not tweaking their own platform, but deciding whose platform to use, from my perspective,” says the managing director at the institutional broker-dealer. “Any time you get a consortium of brokers, it just becomes a bit of a mess. Every broker thinks they’re the smartest guy in the room; they all think their technology is the best.”

Indeed, industry partnerships are, at the best of times, hard to manage. Just ask the participants in Project Colin, the failed attempt to build an industry utility for post-trade processes, or the length of time it takes to get much of anything accomplished in industry working groups without a formal structure or organization, such as FIX Trading Community, to guide them.

A person familiar with MEMX’s thinking says that it’s still early days for the would-be exchange, adding that its board—which includes representation from each member firm—will make decisions about technology, and is actively recruiting personnel.

“They’re hiring staff for technology platforms, for running relationships, and for management,” the source says. “It’s very early in the process. The main focus right now is on filing and getting the application approved with the SEC.”

But technology questions aside, any exchange lives and dies by one sword—liquidity.

“Building a venue, liquidity begets liquidity. The last thing I want to do is build a venue, tell all of my clients to route there, and then nobody gets any fills and they have a bad experience,” says the managing director. “One of the benefits that this place will have is from day one is that if Morgan Stanley, UBS, Virtu, and others send all of their flow, then it’s going to be a viable marketplace.”

Much depends on how MEMX’s founders envisage its future growth, and the level of investment required to achieve those goals. Although it’s true that exchanges invest a lot of money in building and maintaining technology to run their exchanges, Grasshopper’s Lin believes it is possible for MEMX to succeed if the scope of its ambition is realistic.

“They do not have to be beholden to a small common denominator. That is hard work. They can just take care of their members, with perhaps an offering to others that want to participate,” he says.

Lin adds that MEMX only has to mimic the current efficiency status quo, and offer moderate savings in exchange fees and data costs. “It’s a brilliant move, as they have already gotten close to a critical mass of major participants,” he says.

A wider expansion of the platform in order to truly challenge trading volumes—if not listings—on Nasdaq, NYSE and Cboe, however, will require the participation of retail flow. That may be a challenge in the modern trading environment, where the narrative has tended towards separating retail trading from high-speed, technologically advanced operations, or by leveling the playing field through the introduction of speed bumps or randomized pauses during the execution process.

As such, the relationship between retail and institutional brokers has tended, at least in recent years, towards the antagonistic. A substantial part of the challenge that MEMX faces will be balancing the interests of the institutional and retail segments in the same pond. MEMX has anticipated this in the composition of its membership, given the presence of TD Ameritrade, E*Trade and other retail-focused brokers, but it will need to attract wider participation to truly succeed. This will require a delicate approach to interests that may ultimately compete with, rather than compliment, each other.

“If you get the right personalities in the room, you can bring up everybody’s agendas and say that ‘These are the major sticking issues for you as the institutional guys; here are the objectives of the retail guys’,” says Fador. “And then, you know, the technology will get decided once they sort of get agreement around what this thing looks like. Ultimately, what’s the objective?”

Indeed, more than low-latency connectivity, order routing, matching engines, or any other technological trinket, the existential threat to MEMX is likely to come from within.

“The biggest hurdle will be themselves,” says the institutional broker. “Like I mentioned, getting seven brokers who all think they’re the smartest guy in the room to agree on anything will be difficult. You’ve seen this before in potential tie-ups. It’s easier said than done, let’s say.”