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February 1, 2002

Abolish Access Fees!

By Sanjiv Gupta

A series of significant pricing changes for SuperSOES, recently announced by Nasdaq, is supposedly designed to centralize customer orders and increase liquidity for market participants. Nasdaq not only mandates an access fee for all market maker liquidity in SuperSOES, but also positions itself as the collector of those access fees.

Then, in an arrangement tantamount to payment for order flow, Nasdaq rebates half of the access fees to the market makers providing liquidity while retaining the other half for itself.

Clearly, the new pricing structure weaves access fees and payment for order flow much deeper into the fabric of the National Market System (NMS).

ECN Liquidity

Access fees have been much debated and criticized. Before 1997, ECN liquidity was private and required members to pay commissions to access it. The order handling rules mandated the inclusion of ECN liquidity as part of the NMS by requiring it to be displayed in the national quote montage.

The rules also mandated that ECN liquidity be equally accessible to all market participants via SelectNet. Access fees allowed these systems to continue to collect commissions from both sides of every trade even when an ATS had only found one side of the trade.

Whether access fees made sense in 1997 is open to debate. However, much has changed since then. Average spreads have declined tremendously since the order handling rules, the creation of ECNs, and decimalization. Now, active issues often trade with a penny spread.

Concurrently, ECN market share has grown to over 40 percent of Nasdaq volume with ECN clients often controlling the inside quote. Best execution pressures also require brokers to execute against the best bids or offers in the marketplace without regard to access fees.

What's bad about access fees? For one thing, they are unfair to market makers. They create artificial distinctions between ECN and market maker liquidity. For another, they distort what's good for order flow, shifting it away from service, liquidity, and other execution values and towards payment for order flow. Access fees add to everyone's execution costs, costs that deliver no benefit to the marketplace.

Nasdaq has provided no indication that the fee increases are based on increases in costs. Instead, it has suggested that the higher fees are necessary because SuperSOES, by reducing the number of orders required for the trading of a given volume of shares, has lowered costs for market participants and, correspondingly, lowered revenue for Nasdaq. The per-share charges are defended as being consistent with industry practices.

When referring to industry practices, Nasdaq chooses to compare itself to other brokers. Nasdaq, however, does not act in the capacity of a broker - executing, clearing and assuming counter-party risk. Nasdaq's actual role is to act as a central quote aggregator and disseminator, or SIP (an exclusive securities information processor), and as a network service provider.

Typically, private network service providers charge a flat monthly fee for unlimited usage, or per-order-routed fees. Even the NYSE's SuperDOT network, a directly comparable service, charges 80-90 percent less than the new SuperSOES fees.

The fact that fees for SuperSOES are increasing while they could be diminishing in a competitive environment only underscores the fact that the fee increases are based upon Nasdaq's monopoly pricing power. The fee increases are not based on increased costs or other factors arising from an open and competitive market in the services being offered. The new SuperSOES pricing structure is a negative development for the NMS.

Nasdaq Dominance

Nasdaq's sudden embrace of access fees and rebates does nothing to remove marketplace distortions caused by access fees, or to encourage value-added innovation.

Rather, the goals of the new scheme are to establish the dominance of Nasdaq's execution facilities and to enhance its own revenues.

Nasdaq should be using its influence to abolish access fees rather than making these fees ubiquitous. Nasdaq is a stock market. The role of Nasdaq should be to act as an impartial clearinghouse that doesn't favor one set of market players, including itself, over another.

Sanjiv Gupta is director of trading research and strategy at Bloomberg Tradebook LLC., an NASD member firm.