Stock exchanges and data providers find attractive revenue opportunities in selling exclusive colocation facilities and high-speed data services, respectively, but eventually they might end up killing the golden goose. If more and more investment traders buy those services, not only does the exclusivity they covet get diminished, but investors that do not buy them perceive financial markets as rigged and drop out. The upshot of that turn of events is reduced liquidity (or transaction volumes) in markets, and the smaller pie reduces opportunities for all participants.

A stock exchange or an information services provider could avoid that reversal of fortune by finding the right price point for their exclusive offering by which they could control the sequence of events leading up to market outcomes such as liquidity. Wharton finance professor Vincent Glode and University of Colorado finance professor Xingtan Zhang have designed a mechanism to find that price point based on a research model they created. In their recent paper titled “Arms Sales in Financial Markets,” they studied “how a monopolist (e.g., a data provider or a securities exchange) can maximize the profits from providing a good or service (e.g., data or colocation services) that improves the position of a subset of traders at the expense of their counterparties.”

How ‘Arms Races’ Scare Investors

According to the paper, financial markets promote “arms races” when some participants secure resources whose only purpose is to gain a relative advantage over rivals, such as colocation facilities or superior data access. Unsophisticated investors who do not have those resources may exit the financial markets because they perceive them as “rigged” against individual investors, thus reducing liquidity, the authors explained. The paper cited a Bankrate survey that found that 41% of Americans who do not participate in the financial markets agreed with that perception.

“As long as you’re able to use that advantage against somebody else, you will be willing to pay a price for it.”— Vincent Glode

Many exchanges sell colocation offices in nearby locations as a way to earn revenue, Glode noted. Institutional investors, hedge funds, and other market makers with large trading volumes are willing to pay high prices for those facilities that are close to an exchange’s data servers; the same reasoning applies for the premium they are willing to pay for fast-trading technology and faster data access.

Glode explained how those benefits could become a liability for the buyers of such services and a losing proposition for entities such as stock exchanges. “As long as you’re able to use that advantage against somebody else, you will be willing to pay a price for it,” he said. “But it becomes a problem when your counterparties worry that you have an informational or speed advantage and they are afraid of trading against you. As investors exit financial markets, liquidity drops, and the informational or speed advantage becomes less valuable,” he pointed out.

Glode said stock exchanges and data providers must recognize that their services are more valuable when financial markets are highly liquid. “They must sell enough of those services, but not too much,” he added. “What we show is that in many situations there are excessive sales of these advantages, suggesting that the price might be too low, which then leads to too many traders buying them. That leads to many traders who didn’t buy those advantages leaving the market and a reduction in liquidity.”

Prior research has focused on the incentives of investing in resources such as information, expertise, and fast-trading technology. The paper by Glode and Zhang advances that discourse by focusing on the pricing of those resources by monopolist suppliers like stock exchanges and data providers, and how they must weigh the impact on market participation and liquidity. “With our model, we predict that the firms or traders that are most willing to pay for those advantages are those that are expected to provide the most liquidity in the markets.”

“There is a big cost of this in terms of investors’ low participation and the destruction of liquidity.”— Vincent Glode

A Shifting Playing Field

Glode and Zhang set out the backdrop for their case with a quote from the book Fast Boys by Michael Lewis, which talked of “collisions” between high-frequency traders and ordinary investors, and how “around those collisions an entire ecosystem had arisen.” That setting has come about over time and with growing inequities. “It used to be that people who didn’t have a lot of wealth were the ones who didn’t participate in financial markets,” he said. “But now, even people with wealth are saying, ‘I’m not participating in financial markets because they’re rigged. Instead, I will invest in cryptocurrencies or other assets because I just don’t trust traditional financial markets like the equity market.’ So we have a new type of nonparticipants: people who are sophisticated enough to know that these markets might be too dangerous for them.”

According to Glode, securities regulators must pay close attention to offerings of colocation services in order to preserve liquidity in the financial markets. “Exchanges need to be careful with colocation because it’s feeding back into investors’ decisions on participating in those markets.”

Glode said the trigger for his research was the practice of stock exchanges collecting premiums for selling colocation facilities with proximity to their servers. “We started working on this because we were shocked that this was part of a stock exchange’s business model,” he said. “Stock exchanges are typically trying to promote liquidity.  And it’s hard to believe there’s a social need for trades that only take a few microseconds to execute. But as we highlight in our paper, there is a big cost of this in terms of investors’ low participation and the destruction of liquidity.”