Equity Markets Are Highly Competitive

In the past few weeks, we have shown data on the growth of dark trading and the increasing fragmentation of lit exchanges. Today, there are 16 equity exchanges, over 30 ATS venues, and more than a hundred brokers in the U.S. — and they’re all competing to provide trading services. 

That sounds like a lot of fragmentation in the market, which at some point might result in more costs than benefits to investors.

Today, we’re going to use the same test the U.S. Department of Justice (DOJ) uses for mergers. That test shows that the U.S. stock market is, already, highly competitive.

The DOJ uses HHI as a measure of competition

The DOJ uses the Herfindahl-Hirschman Index (HHI) when considering the antitrust implications of mergers and acquisitions. The HHI, based on the work of economists Albert Hirschman and Orris Herfindahl, uses the market share of all the firms in an industry to measure how concentrated it is. 

In simple terms, the HHI index is created using the weights of each company in an industry. To do this:

• Each company’s market share is squared (this makes larger companies count much more).
• Then, the scores are all summed up.

We show some examples of how the math of HHI works in Chart 1 below. The more concentrated “Industry A” scores 3400, while the more competitive “Industry C” scores 900. 

Chart 1: Competitiveness changes based on the number of firms and their market shares 

In the DOJ’s view, an HHI score above 1800 is uncompetitive, from 1000 to 1800 is moderately competitive, while an industry scoring below 1000 is highly competitive. 

Although, to be fair to the DOJ, they actually use two scenarios when testing mergers. Since they are concerned if a merger could “substantially lessen competition” or “tend to create a monopoly,” the department also looks at whether the merged firm’s market share is over 30% and, if so, the merger increases the HHI by 100 points or more.

HHI says U.S. trading is a highly competitive industry

We can also apply the HHI math to U.S. equity markets. 

We show all the different participants over recent years as colors in the chart below.

We then make some conservative assumptions: 

• Adding all exchanges in the same group together.
• Using a generous value for “Other Brokers,” which are aggregated in FINRA data.

Based on that, the industry has an HHI score of 874 in Q4 (chart below, black line). We also calculated the HHI for Q4 using recent firm-level data, which isn’t available historically, and got a score of 900. So, by either method, that makes the U.S. equity market not only highly fragmented, but also highly competitive.

In fact, for the last two years, the HHI has been in the Highly Competitive range or right on the threshold. In addition, no exchange group has a market share close to 30% (bars). So, the U.S. equity markets also look most like “Industry C” above.

Chart 2: The equity market is highly competitive and only getting more competitive over time

U.S. market is only getting even more competitive

Since 2020, three new exchanges have been established, and there are five more exchanges planning to start operations this year or early next year, along with four more ATSs. That pushes the total number of venues well over 50.

In reality, U.S. market economics actually support new venues over existing ones. So, it should be no surprise that the HHI score has been falling (chart above, black line). We estimate the industry’s HHI score was around 1350 at the start of 2019, right in the middle of the Moderately Competitive zone. Now it’s well into the Highly Competitive zone and heading lower.

In short, the U.S. market has been getting more competitive.

Balancing competition with fragmentation

So, while regulators sometimes question whether the market for trading services is competitive, the hard data shows it’s not just competitive, but highly competitive.

At some point, though, the question for regulators will become how to balance competition with fragmentation. Fragmentation adds to fixed costs for hardware, broker connections, exchange programmers and management. For investors, opportunity and search costs are higher. And not all venues care about capital formation for the newest growth companies.

That matters when you consider that the SEC’s mission includes maintaining “efficient markets,” too.