Venturing into the uncharted: how carefully created venture exchanges can succeed while bolstering the American economy.

• Author: Rahn, Evan

1. INTRODUCTION II. BACKGROUND: THE IMPORTANCE OF ELECTRONIC TRADING, SMALL SECONDARY MARKETS, AND LEGISLATION'S POTENTIAL IMPACT A. Rise of the Machines B. Private Markets: GSTrUE and NASDAQ Private Market C. Current Venture Security Markets: The American Stock Exchange's Emerging Company Marketplace and the TSX Venture Exchange D. Legislative Involvement: The JOBS Act and the Main Street Growth Act III. ANALYSIS: WHY HAVE SOME MARKETS FAILED WHILE OTHERS SUCCEED? A. GSTrUE B. NASDAQ Private Market C. Venture Security Markets: The American Stock Exchange's Emerging Company Market and the TSX Venture Exchange D. Legislation: Strengthening the Secondary Market with the JOBS Act and the Main Street Growth Act IV. RECOMMENDATION: A CONSIDERATION OF POTENTIAL EXTERNAL AND INTERNAL FACTORS AND FREEDOMS A. External Factors 1. Timing 2. Investor Demographics 3. Legislation B. Internal Factors V. CONCLUSION I. INTRODUCTION

   Imagine a thriving country as a reliable, ever-running car. A strong economy is the engine, the essential force behind the car's reliability and productivity. Yet to start--much less continue--running, the economy engine requires, at the very least, gas. This metaphorical gas is jobs (1) and gas is pumped from a station. While there are a variety of stations to choose from, one gas provider is entrepreneurial capital formation. These "[d]ynamic small and start-up companies are critical to job creation." (2) To provide more jobs and "promote general prosperity," these companies must continue to grow. (3) Liquid venture security markets can deliver this growth, but success will require a proper balancing of legislative structure and market freedom. (4)

   Part II offers a brief background designed to acclimate the reader with the terminology and history of the financial marketplace. This includes a discussion on the beginning of the stock exchanges, electronic trading's rise to importance in Part II.A, and an introduction to small private and venture exchange markets in Parts II.B and II. C, respectively. Part II concludes with a description of two pieces of legislation that may affect or serve as templates for future venture security market regulation.

   Part III analyzes and considers why certain small secondary exchanges have found success and continued viability while others have been quickly closed as failures. This necessarily entails further discussion of market vocabulary and history. It also examines two pieces of legislation, one of which was enacted but is yet to be fully implemented, while the other has failed to garner the needed amount of congressional support. The analysis shows that both are helpful backdrops but fall short and will fail to fully support the creation of stable and profitable venture exchanges.

   Finally, Part IV provides a variety of recommendations for the creation of a venture exchange. Based on the history of large exchanges, electronic trading's rise, and proposed legislation, combined with lessons learned from both the failures and successes of small secondary markets, the recommendation outlines the ideal result: multiple venture security markets supported by a skeleton of federal legislation and bolstered by the freedom of each market's chosen set of rules. Unshackled by various current regulations, these venture markets will compete in a capitalistic "survival of the fittest," leaving the strongest few to lay groundwork for a liquid market consisting of small capital companies, the very companies that drive the economy through baseline job creation.

2. BACKGROUND: THE IMPORTANCE OF ELECTRONIC TRADING, SMALL SECONDARY MARKETS, AND LEGISLATION'S POTENTIAL IMPACT

   To understand the past problems and potential for success of venture security markets, one must first understand the history and inner-workings of the largest U.S. exchanges, like the New York Stock Exchange (NYSE). The NYSE truly began in 1792, when a group of 24 brokers agreed to trade exclusively with each other, in reaction to oppressive government bond merchants. (5) By 1886, the exchange had greatly expanded and was trading over one million shares a day due to the railroad, canal, and bank expansions. (6) Functionally, traders constantly called out "asks" and "bids" to measure the market, leading to specialists, who served as market makers. (7) Throughout the next century, the exchange saw the addition of technologies, like telephones and electronic tickers, and experienced the terrors of a volatile market. (8) By the 1930s, Congress began to implement regulatory legislation, like the Securities Exchange Act. (9)

   While it has a long history that provided a strong base, the NYSE's secret to success is liquidity. Liquidity refers to a security's ability to be readily sold. (10) There is a strong positive correlation between the value and liquidity of securities. (11) Greater liquidity creates more opportunities and more opportunities draw more investors. (12) More investors create capital for companies. (13) More capital provides companies the opportunity to garner more revenue, thus opening opportunities for job growth, stock gains, and possible dividends. (14) Essentially, liquidity is the lifeblood of the financial market and the U.S. economy as a whole. (15)

   The greater the liquidity of a security, the more the value of the security will increase. (16) Though billions of shares are traded across the NYSE platform each day, (17) the current key to the NYSE's liquidity is electronic trading and its purchase of Archipelago, one of the earliest and most successful Electronic Communication Networks (ECN). (18)

   1. Rise of the Machines

      Stock exchanges have always been slightly behind forward-moving traders and brokers. This proved true with technology and electronic trading, beginning with the SOES Bandits in 1988. (19) NASDAQ had created the Small Order Execution System (SOES), which allowed smaller traders to instantaneously execute orders. (20) This sped up the traditional process, which had required an in-person or telephone call order. (21) Though some traders previously used SelectNet, a computer system that transmitted information about bids and asks, the system would not electronically execute the trade. (22) It worked "much like a primitive instant message system," and required market makers to execute the order by hand. (23) This gave market makers an incredible amount of power--they could essentially ignore orders from some traders and implement trades with others. The system was still steeped in the same oppressive practices that the original (24) brokers had sought to avoid. (25)

      But the SOES Bandits sought to level the playing field (and make quick money). (26) With the SOES system, day traders had access to the same information, at the same time, as the market makers. (27) Because there was equality, traders could move quickly and buy at advantageous prices. (28) "When the market for a stock started to shift--say, offers to sell Microsoft jumped from $50 to $50[.50], while the buy offers rose from $49[.75] to $50[.25]--some market makers might be caught napping, still offering to sell at $50." (29) Though not technically illegal, the Bandits were profiting and the trading was recognized as an "evolutionary shift." (30)

      With the goal of further creating transparency in the market (by avoiding the market makers), trader and computer genius Joshua Levine created a program capable of quickly moving in and out of stocks, like the Bandits, but with algorithms instead of human commands. (31) The creation was named Island, a conglomerate of complex algorithms and an ECN that quickly took over the market and promoted an "arms race" to create the fastest, strongest, and most reliable liquidity-pumping ECNs possible; this scarcely-regulated practice led to the "Flash Crash" in 2010. (32) The idea of an ECN is simple but incredibly productive: match buy and sell orders, the asks and bids, and route the order to the large exchanges. (33) Island was revolutionary and allowed traders to skip the market-makers, interact directly, and input orders that could be matched with asks. (34) With greater transparency--the quotes were posted on a website--came greater liquidity because traders could quickly jump in and out of stocks, meaning there was a near constant buy-sell continuum available. (35)

      Due to electronic trading's great success, many banks or private businesses run Alternative Trading Systems (ATS). (36) Regulation ATS is the main source of control over these systems; otherwise they are comparatively unshackled by the SEC. (37) Their popularity and importance has grown so much that even shutdowns of the NYSE leave the market and investors with little adverse effect. (38)

   2. Private Markets: GSTrUE and NASDAQ Private Market

      Several of the most successful financial institutions, namely Goldman Sachs and NASDAQ, have attempted to launch private security markets. (39) Both were utter failures. The Goldman Sachs Tradable Unregistered Equity (GSTrUE) platform began in 2007. (40) Viewed as precursory try-outs for public listing, small companies sought to raise money through institutional investors while avoiding the costs and publicity of a public offering. (41) The platform also attempted to offer transparent pricing. (42) Goldman claimed GSTrUE brought "the liquidity of an exchange with the flexibility of a private placement." (43) But by 2012, Goldman had closed GSTrUE, citing a lack of liquidity as the main culprit. (44)

      In 2011, NASDAQ launched its BX Venture Market, but it failed so quickly that there is little information on the attempt. (45) It sought to bring together "early-stage companies and companies not listed on a national exchange." (46) This failure was after a 2007 attempt to create a "regulation-free marketplace for unregistered equity securities." (47) In a last ditch effort, NASDAQ recently launched another private market. This market, aptly named NASDAQ Private Market, has...