Comment and Discussion

Comment by Hans R. Stoll: Benn Steil's thesis is that exchanges are businesses. Technological change—the automation of the trading process—has produced an "inexorable trend" toward for-profit and demutualized exchanges. Technology gives rise to new and more efficient markets and increases competition. Increased competition causes existing exchanges to respond by changing their ownership and membership structure. With regard to regulation, Steil argues that demutualized exchanges are at least as able as mutual exchanges to carry out self-regulatory obligations.

While I agree with much of Steil's thoughtful analysis, I would like to consider reasons why demutualization will not occur, should not occur, or will be slow to occur. In my remarks, I adopt his useful distinction between demutualized and for-profit exchanges. The key issue is whether there is demutualization—separation of ownership and membership—not whether exchanges are for-profit.

In fact, demutualization has not occurred apace among U.S. equities exchanges. The New York Stock Exchange (NYSE) and the regional exchanges in this country have not demutualized, although some have indicated their desire to do so. Is this simply because of the intransigence of their members, or are there other reasons? I think there are other reasons. These reasons have to do with how we think of exchanges and what they do. Once we know what an exchange does and how that has changed, we can be more clear about how it should be governed.

How Are Exchanges Changing?

The functions of an exchange have not changed much over time. Exchanges provide pre- and post-trade information (quotes and trade prices), route orders from customers to market centers, execute transactions, provide dealers who bridge the gap between available buyers and sellers, and clear and settle transactions.

How those functions are carried out has changed. If we think back to the period before computers, before telephone, and before teletype, an exchange was simple—a coffeehouse where brokers gathered to trade. The exchange consisted of two elements. One was the facility. The second was the brokers and dealers themselves. At the beginning, the particular coffeehouse in which the brokers met was not important. The essence of the exchange was the brokers and dealers who carried out the trades.

Over time, as the process of trading became automated, the facility became more important and the brokers and dealers less so. The coffeehouse built an infrastructure for the different aspects of trading: quote and trade information, order routing, order books, execution facilities, and links to clearing and settlement. Capital was substituted for the labor of the floor brokers and dealers. Steil clearly makes this point.

In the meantime, the brokers and dealers, at first only patrons of the coffeehouse, had become its owners. The coffeehouse became a private club dominated by the floor members. Today, it is precisely these floor members—the original owners of the exchange—who are destined for extinction as a result of new trading technology. The coffeehouse is putting its own floor members out of business. The traditional exchange is competing with some of its own members. Other members, such as the upstairs retail firms, are not threatened in the same way.

Technology has changed the relative importance of different elements of an exchange. The organization of an exchange must change to reflect the new realities. But how exchange governance will adjust and whether demutualization is inevitable remain open questions. Perhaps we are demutualizing some members and remutualizing others.

Demutualization and Remutualization

Steil asks why demutualization has occurred. The usual answers are "access to capital" and "operational efficiencies," but I agree that the primary reason for demutalization is to reduce the control of the floor brokers and floor traders who have run the coffeehouse and who can make change difficult.

The floor members are being disintermediated. Their days are numbered, and demutualization may be one aspect of this general trend. We see this in the shrinking number of dealer firms in all markets. The...