Mr and Mrs 401K behind growing SEC scrutiny of exchange fees

In December last year, the SEC launched its transaction fee pilot, a landmark investigation into the effect of fee and rebate models on order routing, trade execution and general market quality. The pilot involves a test group of 1,460 securities.

Under the maker taker exchange model liquidity providers are given rebates and liquidity takers are charged fees of up to 30 cents for removing liquidity. Under the pilot programme rebates are banned and fees dropped to 10c.

The pilot stems from the widespread belief that brokers route based on the highest rebate on offer, rather than on best execution. There is increasing pressure for order routing disclosure and if rebates were banned, it would fundamentally change the economics of the business for retail brokers.

Unsurprisingly, the exchanges hate it, with Nasdaq and CBOE having declared that: “Government rate making is a discredited vestige of intrusive, Depression-era legislation.” They are not alone in their disapproval. Goldman Sachs, for example, has criticized the pilot as costly and complex, and simply wants a reduced fee cap instead. Others are much more enthusiastic. 

“The SEC pilot could give market makers the ability to manoeuvre and create a new structure,” points out consultant Larry Tabb. “It could give them a way to create different sets of incentives that don’t look like rebates.”

For MEMX, rebates could initially be a useful tool. The consortium is understood to have raised $70 million so far and could use some of this war chest to offer generous rebates for order flow. If rebates are banned, however, it could use ownership rights as an incentive.

But it is not just rebates that are in the SEC’s sights. As the fractious roundtable that the regulator held last October revealed, the topic of exchange data charges is one that many participants want it to take a closer look at too, encouraged after it disallowed two proposed price hikes last year. “Around that time [October] the SEC moved to challenge the rationale for numerous exchange market data fee hikes – that was a material announcement. There appears to be focus from the Commission on market data more broadly. We believe they will continue to encourage increased transparency and competition,” says Khandros at UBS, a MEMX consortium member.

Sarah Sullivan at Capstone DC in Washington believes that: “The SEC’s role is to make sure that fees are fair and reasonable. It was relatively unusual not to allow the fee increase last May and October, which would suggest that they are taking a closer look at the feeds. [SEC Chairman] Jay Clayton views market structure issues as an important component of protecting main street investors, who he often refers to as ‘Mr and Mrs 401K’.”

At the heart of the issue are the SIP feeds, which were first introduced in 1975. The problem is that today nobody can trade on just top of book data – they need the full direct data feeds from the exchanges to get depth of book data as well. This is in order to fulfil their best execution obligations. Unlike the SIP, 100% of the payment for these depth of book direct data fees goes to the exchanges.

“No market participant that desires to route an order effectively and consistent with its best execution obligations can do so without paying for full depth of book market data from 11 exchanges and connectivity from them all,” stated Doug Cifu, chief executive at Virtu at the October roundtable. He then described how the exchanges charge Virtu a total of $1,188,000 per year for six cross-connects – a cable that plugs into the exchange.

“It is provided by a vendor in Hicksville, Long Island, right near where I grew up,” he said. “We contacted them and purchased this spool for $189.” He then shopped around and found the exact same cable for $88 on Amazon. That is quite some mark up.

Many make the argument that because depth of book data is a requirement of best execution then its cost should be subject to regulatory oversight. Firms simply cannot operate using the SIP data alone. Greenwich Associates recently polled traders to establish how many would. “Just 2% of customers will trade on SIP data only,” Greenwich’s Richard Johnson tells Euromoney. “But 34% said they would trade only on SIP if there was clarity that this was best execution.”

With SIP feeds as they are, however, there is little doubt that it is not. “If a broker is routing using just SIP data they are not routing my flow,” declared Mehmet Kinak, global head of systematic trading and market structure at T Rowe Price at the October meeting. In October 2016, part of the SIP was moved to a new system that increased median speed by 95% (from 500 microseconds to less than 20), but it is still inadequate without the direct data feed as well.

Tabb believes that the time has come to revisit the SIP. “The SIP is not fit for purpose,” he says. “But there is little incentive for the exchanges to improve the SIP as the worse it is, the more people have to buy the direct sheet data. If they changed the structure of the SIP governance committee so that the exchanges represented less than 50% of the committee, then they could redefine what a SIP is, which should increase exchange direct feed competition and bring down pricing.”

The SIP governance committee is made up of the exchanges themselves; as a self-regulatory organization (SRO), each exchange gets one seat at the table. As it is clearly in their best interests to keep the SIP as it is – because the sale of the direct data feed is so lucrative for them – the likelihood of reform is slim.

This is at the heart of the market’s grievance. “An ecosystem of a for-profit company that can self-regulate itself and police reform that allows it to get flow is a terrible cocktail that has been created,” warned Kinak in October.

It certainly seems to be on the minds of the MEMX owners. 

“Some important decisions are made without fully considering the views and interests of all market participants – market data governance is an example of that,” says Khandros. “We want to help further improve the policymaking process by including an alternative exchange that will represent a broader spectrum of views and interests.” When MEMX gains its licence it will get one seat at the table, but it will have to create other exchange models to get more voting rights in SRO governance. But it is a way forward. 

“We are hopeful and encouraged by the direction of travel at the SEC. The ultimate goal is to reduce costs for our clients and to put get more information out there,” Khandros explains.

And if this new exchange can eventually exert more influence over exchange regulation, then that ultimate goal of reducing costs for everyone might become achievable. “Brokers don’t have a seat at the table when the NMS rules are set,” says Johnson. “MEMX might be a way for them to get a seat at the table.”