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February 1, 1998

The Market Data's Value

By Gene L. Finn

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  • The Market Data's Value
  • Page 2

How can market makers remain competitive in a hostile trading environment?

They can capture the value of processing customer order flow and charge for the unique aspects of their liquidity services. A good place to start is with the quotation and last-sale information-value of order flow.

Historically, market makers relied exclusively on the bid-and-offer spread to cover the cost of all services they provided to retail brokers.

These services included leased communication lines to clients, computers and software, correspondent fees paid to brokers, publication of quotations, order execution and trade processing, inventory risk and compliance.

Times have changed, of course. The Securities and Exchange Commission-approved order handling rules have essentially eliminated the ability of market makers to capture the spread-revenue on limit orders.

These rules give priority preference to limit-order quotes over pre-existing market-maker quotes, requiring the inclusion of limit-order prices in the National Best Bid and Offer. Consequently, the rules have narrowed market-quoted spreads by about 25 percent.

Regulation, in effect, has forced an unbundling of market-maker revenues. Through a matrix of rules, the SEC is actually keeping market-maker spreads on market orders at a level not exceeding the cost of providing the liquidity services of a limit-order book. Unfortunately, these limit orders cover none of the market makers' regulatory costs.

In contrast, market-maker regulations, such as mandatory SOES and fixed minimum quote sizes, are still in place, forcing market makers to keep extra, costly liquidity services bundled with their quotations. A market-maker quotation is now worth more than an incoming customer limit-order quote, yet the market maker cannot provide these liquidity services exclusively to customers. A competitor, for instance, could hit the market-maker's bid via SOES.

Market makers initially responded to the order handling rules by reducing expenses, specifically eliminating cash payments to retail brokers for unprofitable limit-order flow. Of course, this shifted a significant part of the immediate negative revenue effects of the rules to retail brokers and their customers. Still, market makers are executing limit orders at a loss.

Now they must find new ways to remain competitive. Last-sale information-value of order flow is worth examining.

To begin with, National Market System (NMS) facilities have been allowed to evolve in a manner that requires information-generating enhancements such as last-sale reporting on Nasdaq stocks to increase participants' operating costs. The value of the information is captured by the self-regulatory organizations (SRO) through exclusive management of the central-information processor. Nasdaq is an example of an exclusive central-information processor.

The Chicago Stock Exchange (CHX), as an SRO participant in the unlisted trading plan for Nasdaq stocks, is able to share in the huge subscriber-fee revenues generated by the National Association of Securities Dealers from the sale of last-sale and quotation-price data. In 1996, NASD market-data and subscriber-fee revenues aggregated $222 million.

Market makers and electronic communications networks (ECN) should have as much interest as the CHX in capturing the market-data value of their order flow. After all, they are the producers of the quotation and last-sale information that is being sold.