Innovation in the Stock Market and Alternative Trading Systems

Abstract

Is something wrong with the structure of the U.S. stock market? Both industry participants and scholars have recently faulted the equity market for its lack of innovation. In particular, they have emphasized that stock exchanges may not have the right incentives to provide innovative solutions to market problems. I argue that understanding the quality of innovation in the equity market requires bringing other types of stock trading venues—particularly “alternative trading systems” (“ATSs”)—into the picture. My central claim is that ATSs have markedly superior incentives to innovate than exchanges for reasons rooted in their governing law and business models. First, ATSs face far lighter regulatory hurdles to beginning operations and changing structure than an exchange, and some important regulations that limit exchange experimentation do not apply to ATSs at all. Second, ATSs are subject to fewer disclosure obligations than exchanges, and as a result they can, in practice, retain their innovations as “trade secrets,” while this is exceptionally difficult for exchanges. Third, ATSs and exchanges have different revenue sources. This is important because ATSs benefit less from the status quo market design than exchanges and thus lack reasons to preserve that structure against desirable innovations, especially those reducing opportunities for latency arbitrage. The result is that ATSs produce the very innovations that some scholars have sought, but failed to find in exchanges, such as frequent batched auctions. I use newly available data on ATSs to inform and illustrate these arguments. I conclude by noting that the consequences of ATS innovations for the equity market as a whole are profoundly ambiguous, because it is unclear how much trading volume an ATS can ultimately attract.