In recent weeks, data has highlighted the expansion of dark trading and the increasing fragmentation of lit exchanges. Currently, the United States hosts 16 equity exchanges, over 30 alternative trading systems (ATS) venues, and more than a hundred brokers, all vying to offer trading services.
This considerable market fragmentation could eventually lead to higher costs than benefits for investors. Applying the same test used by the U.S. Department of Justice (DOJ) for mergers reveals that the U.S. stock market is already highly competitive.
The DOJ employs the Herfindahl-Hirschman Index (HHI) to assess the antitrust implications of mergers and acquisitions. This index, developed by economists Albert Hirschman and Orris Herfindahl, utilizes the market share of all firms within an industry to determine its concentration.
To calculate the HHI, each company’s market share is squared, making larger companies weigh more significantly, and then all these values are summed up. For example, a highly concentrated industry scores 3400, whereas a more competitive industry scores 900 on the HHI.
According to the DOJ, an HHI score above 1800 indicates an uncompetitive market, between 1000 to 1800 suggests moderate competition, and below 1000 is considered highly competitive. The DOJ uses two scenarios when evaluating mergers to determine whether a merger could “substantially lessen competition” or “tend to create a monopoly,” additionally considering if the merged firm’s market share exceeds 30% and increases the HHI by 100 points or more.
When the HHI methodology is applied to the U.S. equity markets, it becomes evident that this sector is not only fragmented but also highly competitive. The application of conservative assumptions, such as grouping exchanges and assigning a value to “Other Brokers” as aggregated in FINRA data, results in an HHI score of 874 for Q4. Using recent firm-level data, which is not historically available, yields a score of 900. In either scenario, the U.S. equity market falls into the highly competitive range, with no exchange group nearing a 30% market share.
Since 2020, three new exchanges have started, and five more are scheduled to begin operations later this year or early next year, along with four additional ATSs. This development pushes the total number of trading venues to over 50. This expansion is supported by the U.S. market economics, favoring new venues, as indicated by a declining HHI score. By the start of 2019, the industry’s HHI score was around 1350, but it has since moved well into the highly competitive zone.
While regulators may question the competitiveness of the market for trading services, data demonstrates that it is indeed highly competitive. However, there remains a challenge in balancing competition with fragmentation, which increases fixed costs for resources and raises opportunity and search costs for investors. This balance is crucial, especially considering the Securities and Exchange Commission’s mission to maintain efficient markets.
