Finance Professor Discusses Implications of For-Profit Status of Exchanges

In a Streetwise Professor blog post titled "Blaming SRO Lapses on For-Profit Status: A Straw Man Dining on Red Herring," University of Houston finance professor Craig Pirrong challenged recent arguments that cite the Nav Sarao spoofing case as proof that an exchange's for-profit status (such as that of the CME Group) is incompatible with its role as a self-regulatory organization.

According to Professor Pirrong, for-profit status "has little, if anything, to do with the incentives of an exchange to self-regulate." He explained that the status of the exchange is irrelevant, since incentives to police certain types of conduct are weak for both nonprofit and for-profit exchanges. Historically, nonprofit exchanges "made little effort to combat corners," since the "biggest costs of manipulation fell on inframarginal demanders of exchange services . . . or third parties . . . but exchange volume and member profitability depended on the marginal demanders . . . who were little affected." For-profit exchanges would have faced the same problem, he explained.

Additionally, Professor Pirrong argued that both for-profit and nonprofit exchanges face strong incentives to police harmful conduct, such as the incentive for securities exchanges to restrict insider trading that reduces liquidity, which raises trading costs and leads to lower trading volume. According to Professor Pirrong, exchange incentives to police a particular type of deleterious conduct hinge on how the costs of that conduct are distributed, rather than how the exchange itself is organized or who owns it.

Professor Pirrong argued that for-profit exchanges often have stronger incentives to adopt efficient rules relating to certain kinds of conduct than nonprofit ones. He also asked who might own and control a neo-mutual nonprofit exchange. If it was owned by big banks directly or through their brokerage units, he said, more problems would be created than solved.

Professor Pirrong explained that the reason exchanges were demutualized in the first place had little to do with self-regulation and rule enforcement, and more to do with the shift from "open outcry" to electronic trading. Overall, Professor Pirrong argued, exchange ownership and organizational form "are not the primary or even major determinants of the adequacy of exchange self-policing efforts."

See: Streetwise Professor: "Blaming SRO Lapses on For-Profit Status: A Straw Man Dining on Red Herring."Related news: Finance Professor Calls CFTC Allegations That Nav Sarao Caused Flash Crash "Outrageous" (with Lofchie Comment and Video Selection) (April 24, 2015); CFTC Publishes Appendix to Motion against Nav Sarao (with Lofchie Comment) (April 23, 2015); Article Casts Doubt on Significance and Causes of Flash Crash (April 23, 2015).