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June 30, 2002

Access Fees and Fairness

By William O'Brien

The trading community, living in an era of declining profitability, is under pressure to control costs. The costs include ECN and Nasdaq fees, which are at the center of a controversial debate. At issue, is the fair application of these fees.

Using fees to "influence" strategic trading behavior runs the risk of unintended consequences: Market quality and a trader's choices may be impaired. The current fee-related issues must be analyzed from this perspective.

The debate dates back to the famous SEC order-handling rules. Today, market makers cringe at paying fees to ECNs with which they have no relationship. They also worry about potential arbitration and best execution issues that come with non-payment. ECNs are wary of the potential for customer fee arbitrage if non-customer access fees are further restricted.

Now the integration of some ECNs into SuperSoes has brought the issue to the forefront. At the same time, Nasdaq has begun to collect similar access fees - termed "liquidity provider rebates" - and is distributing them to market makers.

The market values liquidity to the extent of rewarding the trader willing to display a price and a size to the rest of the market. This means that traders who choose not to identify themselves in a posted bid or offer must be willing to pay for the privilege. Accordingly, the question should not be whether an access fee - charged by an ECN or a market maker - is appropriate, but whether this charge is reasonably related to the value provided.

Rebates that overstate the value of liquidity hurt market quality. The obvious outcome is higher transaction costs for liquidity takers. Then there is the unsustainable pool of liquidity created as rebates become the rationale, as opposed to the reward, for posting bids and offers. Spiraling rebates can create irreparable economic damage to market participants without the financial resources to support them. This hurts market competition over the long term.

In these circumstances, regulatory oversight may be a reasonable approach when market forces do not completely establish rates on an equitable basis. The SEC attempted to do this when capping ECN access fees at 1.5 cents per share back in 1997. That may need to be reexamined in light of recent changes in Nasdaq market structure. A balance must be struck to ensure that adequate controls still exist. These controls would compensate the creators and aggregators of bids and offers without causing unacceptable economic and market consequences.

The forms of Nasdaq and NASD fees can also have an impact on market structure. While NASD and Nasdaq fees evolved over time (quite accidentally, actually), Nasdaq must now turn these fees into the low-risk, high-margin revenue streams the market demands of other pre-IPO companies.

The NASD must also grapple with the theoretical line between regulating the broker and regulating the trader. It must grapple with how to charge member firms for the former and Nasdaq for the latter.

Recent proposals to deal with these issues could have an impact on how traders behave. The quote-based charges in SuperSoes and SuperMontage have economic consequences on trading strategies dependent on active quotation management.

Another Step

Nasdaq's pending "fair cost regulation" initiative will take this a step further. That's because more market and quote-based charges for regulatory services will further increase the explicit costs of large market-making operations. These raise questions about who are the beneficiaries of such regulatory services. They raise questions about how to distinguish between business models that have different oversight requirements.

Market making firms should scrutinize all fee revisions - whether by an ECN, an exchange or a regulator - to ensure the proposed changes represent an appropriate distribution of the costs relative to the benefits received. If these measures are not closely analyzed, a new set of fee-driven consequences could be created that would be difficult to scale back.

William O'Brien is general counsel for BRUT ECN.