With a demonstration of solidarity, three of the nation’s largest stock exchange operators are suing the Securities and Exchange Commission in an effort to halt recent rulemaking they say will put them at a competitive disadvantage.
Intercontinental Exchange’s NYSE, Nasdaq, and Cboe Global Markets operate 13 of the 14 U.S. stock exchanges. The crux of their discontent is a pilot program the SEC approved in December. It will limit what certain exchanges can charge for executing trades and similarly place limits on the rebates exchanges often pay brokers. The SEC says these rebate payments, which amount to roughly $2.5 billion annually, may create conflicts of interest by paying brokers for bringing customer orders to whatever exchange pays the most over what may be best, or most suitable, for their clients.
On Dec. 19, the SEC voted to adopt the new Rule 610T of Regulation NMS, authorizing a Transaction Fee Pilot. “The pilot is designed to generate data that will help the Commission analyze the effects of exchange transaction fee and rebate pricing models on order routing behavior, execution quality, and market quality generally,” a statement regarding the rulemaking said. Data from the effort will be used to evaluate whether “the exchange transaction-based fee and rebate structure is operating effectively to further statutory goals and whether there is a need for any potential regulatory action in this area.”
The Transaction Fee Pilot creates two test groups with new restrictions on the transaction fees and rebates that exchanges charge or offer to their broker-dealer members. One test group will include selected exchanges that will be prohibited from offering rebates and linked pricing. The other group will test a fee cap of $0.0010 per share. The SEC will target stocks with average daily trading volumes greater to, or equal to, 30,000 shares with a share price greater than, or equal to, $2-per-share that do not close below $1-per-share during the pilot.
“First and foremost, the SEC should study the data that’s out there and have a clear articulation of what the issue is they are trying to address. Then, make sure that the test is actually designed to get that data and doesn’t have arbitrary carve-outs and strange limitations.”
John Zecca, SVP, North American General Counsel, Nasdaq
The pilot program will require the national securities exchanges to prepare and post on their public Websites, in standardized XML format, transaction fee and rebate data on a monthly basis. Primary listing exchanges also will be required to post on their Websites information about the pilot securities they list and any changes to those securities and their terms. In addition, the program will require the national securities exchanges to prepare and provide to the Commission, on a monthly basis, aggregated order routing data.
The SEC’s action follows a recommendation from the Equity Market Structure Advisory Committee. The initiative will last up to two years, and the Commission will subsequently announce by notice the commencement dates for data collection and the pilot period. Approximately one month prior to the beginning of the pilot period, it will issue the list of pilot securities.
“Overall, our markets are very liquid, very efficient, and the envy of the world,” says John Zecca, Nasdaq’s SVP and North American general counsel. “Obviously, there’s always room for reassessment and maybe even for change. But it is not like we’re starting from a point where things are bad enough that we want to take risky steps to try to change things.”
The pilot focuses on rebates and incentives used to entice liquidity in the market. “The lifeblood of a market is liquidity,” Zecca said. “In order to do that, you want to sometimes incentivize, and we do this through transparent rules that the SEC has approved.”
“Our fees and rebates are designed to incentivize people to come and bring liquidity to our market, particularly in low price or illiquid securities, where often, frankly, the trading experience is different,” Zecca explained. “There’s a lot more interest in let’s say, an Apple versus a small regional bank. The quoted spread—the difference between the offers to buy and the offers to sell—tends to be wider in those stocks, and the amount of stock available at each price point tends to be less for these illiquid stocks. Part of the rebates’ purpose is to bring in investors, incentivize them enough to take a little more risk, and prod them in that direction, as opposed to sticking with the Apples and Facebooks of the world.”
The SEC’s rationale behind the rulemaking and the pilot program is that there’s a need for a study to see whether or not these incentives work, how they work, and whether they influence behavior in a good way or bad way. Fair enough, but in Zecca’s view the plan to “set up these different buckets and test whether there are differences” is the inherent problem. “It’s a fairly big study across hundreds of securities, and the issuers don’t really have any choice on whether to be in or out,” he says. “They are just going to be picked. This is certainly a much bigger pilot than we’ve seen in the past. This is not a small test group to just see what’s happening. This is a major percentage of the market that’s going to be affected.”
“If the question is whether there are incentives that are affecting broker behavior, there’s a lot of data out there already that the SEC should probably study before it starts to collect new data,” he added. “It’s not clear to us that data that’s already out there has really been reviewed in any detail. That makes it harder for us to see the value of doing this.”
Critics of the plan also challenge what they view as the arbitrary nature of the pilot. “If you’re looking to understand these incentives, and rebates, and the impact they have on broker behavior, you need to look at all of the incentives,” Zecca says. “You certainly have to look at all of the market places that are offering them. The pilot doesn’t do that. It excludes all of the alternative trading systems and all of the dark pools [non-exchange trading venues and private exchanges]. So, 40 percent of the market isn’t even subject to study, it is strictly the fees that are happening on exchanges. We think that’s going to distort behavior. People are going to go to the dark pools because they can still get these rebates. It is really going to distort the data.”
Another concern is how the market will be distorted as the SEC’s data-gathering experiment proceeds. For example, consider two exchange-traded funds (ETFs), on the same index, that end up in different buckets. The trading incentives for one is going to be different than for the other, and that may create a competitive advantage.
“I think we just come back to ‘do no harm,’ ” Zecca says. “First and foremost, the SEC should study the data that’s out there and have a clear articulation of what the issue is they are trying to address. Then, make sure that the test is actually designed to get that data and doesn’t have arbitrary carve-outs and strange limitations.”
“There is the true risk of harm in the market here without an obvious benefit that justifies such a such a big experiment,” he adds.
Stacey Cunningham, president of the New York Stock Exchange, expressed her concerns in a Feb. 14 opinion piece published by the Wall Street Journal. “An ill-advised price-control program would reduce transparency and increase volatility,” she said of the Transaction Fee Pilot.
“In practice, the new rule amounts to an unnecessary exercise in government price-setting that will add a new layer of complexity to equity markets,” she wrote.
During the SEC’s public-comment period, the NYSE argued that the pilot “will undermine the ability of market forces to drive capital formation and will fail at its goal of measuring broker conflicts.”
“We said the SEC should focus on protecting the long-term health of capital markets, not experiment with them,” Cunningham added. “The SEC freely admits it has no idea whether its pilot program will help or harm investors. This is a black flag that should worry the White House. The stock market is not a simulation. We operate in a real-world environment with investors’ real dollars.”