The Governance Gap in Fragmented Markets

Yesha Yadav is an Associate Professor of Law of Vanderbilt Law School. This post is based on an article authored by Professor Yadav.

The firestorm of controversy surrounding IEX’s efforts to gain recognition as a national exchange showcases the enormous economic and popular power of exchanges in the marketplace. [1] Exchanges have long offered an organized space for companies to list their securities and for traders to transact in the risk of these securities with one another, ultimately helping investors direct money towards productive, profitable businesses. Today, major exchanges like the NYSE and the NASDAQ intermediate billions of dollars in trades daily and list the securities of companies collectively valued in the tens of trillions. [2]

Perhaps less visible, however, is the essential role exchanges play in governing markets and assuring the safe flow of capital through the economy. By dint of providing access to an all-important economic resource, exchanges are ideally positioned to monitor and discipline public companies as well as the traders who transact in their securities. Unsurprisingly then, regulators have long relied on exchanges to ensure that listed companies and traders meet basic organizational standards, comply with applicable securities rules, and follow industry best practices. [3] In the absence of exchange governance, investors would have to take on this task privately and would rationally reduce the capital they invest in response to the added costs of surveillance.

My article, The Governance Gap in Fragmented Markets, argues that our reliance on exchange governance is deeply misplaced in modern, fragmented markets. Theory holds that exchanges make effective monitors because they can gather an enormous swath of equity market participants within their venue. These large numbers enable exchanges to match traders, pool information on their activities, and meaningfully discipline users by threatening exclusion from this key source of capital.

This advantage, however, no longer holds true for exchanges in U.S. equity markets. Owing to regulatory policy in the last decade, today’s markets comprise a fragmented network of 12 national exchanges and around 37 active, non-exchange, trading platforms (or “dark pools”) fiercely competing to attract equity order flow. [4] Whereas the NYSE might once have seen around 80% of all secondary trading in its listed securities, this figure now hovers around 20%. [5] In 2015, dark pools attracted approximately 34% of all U.S. equity trading volume—almost as much as the NYSE and NASDAQ put together. [6]

This article makes two points. First, in fragmented markets, governance represents a bad business proposition for profit-seeking exchanges. For one, their actual task is much harder from a logistical standpoint. Today’s equity market structure institutionalizes information asymmetries. Exchanges must determine how their traders transact across other exchanges and the multiplicity of active dark pools. Most dark pools are not required to post buy-and-sell quotes pre-trade. And availability of their post-trade data is subject to delays. [7] These structural informational gaps force exchanges to invest in gathering insights from across the market and coordinate with competing lit and dark platforms to determine whether those using their venues are well behaved.

Importantly, due to intense competition, ever-decreasing trading volumes strain the financial resources available to exchanges to investigate, supervise, and sanction. And diligence can easily backfire. Strict discipline might not only dissuade traders from using their platform, but it may also encourage misbehaving traders to move to a competitor, like a dark pool. Perhaps more worryingly, the high costs of governance combined with lower returns from trading can deepen existing conflicts of interest endemic to relying on for-profit exchanges to discipline those that also bring them business. Revenue pressures can push exchanges to form increasingly thicker commercial relationships with their users. Indeed, exchanges today routinely sell products and expertise, such as data, consulting, and reward traders who attract business to the venue (e.g. through “liquidity rebates”). Zealous exercise of discipline can cause exchanges to lose these lucrative revenue streams as well, such that they may well possess even less incentive to punish paying customers.

Secondly, within an interconnected network of for-profit exchanges and dark pools, exchanges have incentives to underinvest in governance. In a consolidated market, where trading is concentrated in a small handful of venues, an exchange more fully internalizes the gains and costs of its supervisory efforts. It enjoys the benefits of a job well done, such as more traders coming to the market. Yet it also absorbs the costs of weak oversight, for example, if prices on its venue are skewed because of pervasive fraud or manipulation.

By contrast, in a fragmented market, investing in oversight benefits the exchange privately—but also confers value on its competitors who can then free ride off the exchange’s regulatory efforts. Crucially, an exchange does not internalize the full costs of its poor oversight. As traders and information move quickly between multiple venues, risks created on one exchange can move rapidly to others and across the system of trading platforms. [8] Put differently, an exchange can benefit privately by providing sub-optimal oversight and winning business from competitors. The risks it generates, however, are partially shared with other venues in the system. Despite the proliferation of trading platforms, then, fragmentation diminishes the incentives of any single venue to invest optimally in governance.

The governance gap in fragmented markets is profoundly damaging for the regulation of capital in the economy. Recognizing the importance of private governance for efficient capital allocation, this article concludes by exploring the creation of a new liability regime for exchanges and dark pools. Building on earlier writings, this new liability regime seeks to hold exchanges and dark pools more fully liable for governance failures. It further proposes the creation of an industry fund as a financial backstop to pay out on claims if individual platforms cannot. The goal of this proposal is to encourage robust self-monitoring between venues and create economic skin in the game for trading platforms, aligning their incentives to more adequately conduct good and effective governance in the marketplace.

The full article is available for download here.


[1] Securities and Exchange Commission, Investors’ Exchange, LLC; Notice of Filing of Application, as Amended, for Registration as a National Securities Exchange under Section 6 of the Securities Exchange Act of 1934, Release No. 34-75925 (Sept. 15, 2015); Phillip Stafford & Nicole Bullock, IEX Applies for Full Exchange Status, Fin. Times, Sept. 16, 2015. For critical perspectives on the application, see for example, Letter to Brent J. Fields, Secretary, SEC, from Elizabeth K. King, General Counsel & Secretary, NYSE Group (Nov. 12, 2015).
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[2] Nasdaq, Access Capital,; ICE, New York Stock Exchange Leads in Global Capital Raising for Fifth Consecutive Year, Press Release, (Dec. 15, 2015).
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[3] See, Exchange Act § 6(b)(1) & (5); Exchange Act § 15A(b)(7), 15 U.S.C. § 78o-3(b)(7) (2000); D.L. Cromwell Inv., Inc. v. NASD Regulation, Inc., 279 F.3d 155 (2d Cir.2002). Stavros Gadinis & Howell E. Jackson, Markets as Regulators, 80 S. Cal. L. Rev. 1239, 1244 (2007).
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[4] Calculating the number of dark pools is difficult. This article uses the number of platforms that report weekly trading data to FINRA. FINRA can exempt certain ATS from reporting under Rule 4552. The number of dark pools registered with the SEC numbers is around 80. See Securities and Exchange Commission, ATS List,; Finra, ATS Transparency Data,
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[5] Stephen Diamond & Jennifer Kuan, Governance Heterogeneity and Performance at US Stock Exchanges: Evidence from Regulation NMS, (Mar. 2012) (working paper); BATS Trading, Market Volume Summary Help,
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[6] Annabella Ju, A Top Rival of Dark Pools Admits They Do Have a Purpose, Bloomberg (Feb. 5, 2015). For NYSE and NASDAQ annual equity trading volumes, see Nasdaq, Equity market Share Statistics,
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[7] Finra Rule 4552,
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[8] See, e.g., Austin Gerig, High-Frequency Trading Synchronizes Prices in Financial Markets (Nov. 2015) (working paper).
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