The economic fallout from Covid-19 has been vast. But amid the many losers there were some clear winners. One group in particular is the exchanges themselves on which financial trades take place.

Because the volatility in financial markets meant trading volumes spiked. The FT reported that in March the churn of trade on public exchanges in Europe soared to €69bn-a-day, a 60% year-on-year increase, while in April the London Stock Exchange group (LSE) posted a 13% increase in gross profits for the last quarter.

Yet it is not just a general increase in trading that has helped groups like the LSE. The market uncertainty meant professional investors momentarily stepped out of ‘dark’ private exchanges and into the transparency of the traditional public exchanges instead.

Though momentary this is notable. Because as Walter Mattli describes in Darkness by Design (2019), in the last thirty years there has been a major shift in the way capital market trades take place. The traditional public Stock Exchanges, where stocks are listed and prices thrashed out in the open on the trading floor, has been replaced by ‘darker’ trades taking place within private ‘broker-dealer’ firms.

The old Exchanges were household names like the London and New York Stock Exchange (NYSE), and they occupied near monopoly positions. Even up until the end of the 1990s over 80% of all US domestic equity trading took place on the NYSE. Today it’s less than 25% (2019: 2).

This shift has had a major impact on the operation of financial markets and who dominates. For most of their history, there were strict rules governing who was allowed to be a stock exchange member and what role they could play. The typical member was a small broker partnership that would specialise in a particular area. Some handled retail clients, others wholesale, and different brokers specialised in specific kinds of stocks.

Investors looking to buy or sell stock would have to commission these specialist members to execute the trades on their behalf. Brokers, then, were agents who did not deal for themselves, and whose individual success depended on the integrity of the Exchange as a collective whole.

This began to shift in the 1970s with the concentration of investors into large institutional funds like pension and insurance funds. Rather than small trades to execute, brokers would have large buy and sell offers from clients. And rather than pay public exchanges the costs of executing trades, they brought the operation in house.

This environment was punishing for small-scale specialist firms. They were unable to take on the large orders from big institutional investors and lost market share to the bigger firms. Moreover, exchange platforms – whether traditional or private – have a network effect: the larger the client base, the more opportunity there is for matching buyers to sellers, and the greater the liquidity in the market.

So alongside a concentration of investment funds, there was a spate of mergers and acquisitions between brokers. Old partnerships became PLCs and these grew even bigger when rules were changed through the 1970s to end the fixed commissions brokers received, open up membership domestically, and then to allow foreign entrants into the exchanges. All of which saw the bigger houses swallow up first market share and then the smaller firms themselves.

This became all the more significant in the push against the separation of deposit-taking banking and commercial banking. Though formally ended with the repeal of the Glass-Steagall act in 1999, the dividing wall had been breached as early as 1958 when First National City, one of the biggest banks in America, established an umbrella holding company under which separate specialist units sat. Within a year 800 banks had followed suit and retail and wholesale units, brokers and dealers, were brought under the same roof (ibid: 35).

Once specialist houses, like Lehman Brothers, Bear Sterns, Goldman Sachs and Salomon Brothers became broker-dealer behemoths, trading investor money alongside their own and coming to dominate the securities market in the NYSE.

The same pattern happened in London. At the end of the last century, 20% of the 298 LSE member firms accounted for 80% of the value of all floor-trading business. The largest members were the American and European broker-dealer conglomerates that ruled in New York. Unsurprisingly, by 2016 LSE’s market share of total securities trading in the UK was 55%, a steep fall from its once near monopoly dominance (ibid: 55).

This shift away from transparent exchanges presents a multitude of problems. The moral hazard of ‘too big to fail’ institutions is well known. But investors are also hit by the fact the conglomerate banks know more about ‘the market’ than investors. And from this information asymmetry profits can be made. Client orders can be directed to in-house exchanges rather than necessarily the cheapest place, with the big firms taking the commission. But even more importantly money can be made from the spread between buy and sell prices. Since the broker-dealers often are the market, they can take positions against client flow of money, or even induce price shifts, and then slice off arbitrage profits.

Moreover, their panopticon position atop the market means the broker-dealer banks possess an enormous wealth of data. This is a highly marketable resource in itself.

Information asymmetry has always been the base for arbitraged profit. But now that the capital market has been fragmented between large banks rather than concentrated in transparent exchanges, opportunities are rife. This proprietary information is sold at vast expense to professional fund managers and specialist trading companies, often before the information finds its way out to the broader sphere where everyday investors might operate. The differential information, and the possibilities for arbitrage it presents, has driven a surge in trading traffic.

A decade ago there were millions of orders a day, today there are many billions. It is what makes high-frequency trading so profitable. Yet accessing, storing and processing such large amounts of information to undertake HFT arbitrage strategies requires very sophisticated specialist IT hardware. One Chicago-based HFT company, Citadel, is said to have a data centre containing “the rough equivalent of approximately 100 times the amount of data included in the Library of Congress” (ibid: 105). The fixed costs of being able to work this data is well out the reach of what even the biggest institutional investors could afford.

This is hitting real economy investment. It is not simply that the technology-driven pace of trading churn is out of kilter with real economy productive investment, it is that market liquidity becomes a key criterion of investor choice. Trading, rather than investing, is what matters. As such it is securities that can be readily and rapidly traded are favoured. The result has been that equity investing has been concentrated in an ever narrower band of established securities, and liquidity for smaller stocks has deteriorated.

The politics of this are revealing. Fund managers are dependent on the broker-dealer banks who together profit at the expense of investors. It is clear then, that investors are losing out as much as real economy borrowers. Rather than rentier shareholders, it is the intermediary conglomerate banks and fund managers pocketing handsome returns. This managerial dynamic is part of the secular stagnation of economic growth that long predated both this current Covid-19 crisis and the 2008 financial crisis.

Given the vast financial capacity central banks have unleashed to breathe life back into financial markets – an intervention that stimulates the trades through which private exchanges gain so much – there is clear public power to harness. What Darkness by Design demonstrates is how this must urgently be turned to redesigning the architecture of financial trading itself.