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January 31, 2008

The Pricing Spread End Game

By Nina Mehta

Maker/taker spreads have collapsed. While exchanges and ECNs have pushed their rebates higher over the past several months to attract limit-order traders, their liquidity-taker charges hit a Securities and Exchange Commission-imposed ceiling for access fees at 30 cents per 100 shares.

The upshot is that spreads have decreased at nearly every market center from 10 cents per 100 shares a couple of years ago to just 1 cent today. The phenomenon begs the question of whether players can survive at those price levels.

"There's continuous competition," said Joe Ratterman, president and CEO of BATS Trading. "That's forcing market centers to respond. Customers we all have in common are seeking more aggressive economic benefits." Ratterman noted that his ECN has driven some of the pricing changes at exchanges.

Half a dozen years ago, Brut and other ECNs established the 20/30 pricing structure for Nasdaq-listed securities. Now, maker/taker pricing has been extended to all National Market System names and the spreads are razor-thin--or nonexistent, in some cases.

The National Stock Exchange and one of Direct Edge ECN's markets, EDGA (the latter for customers that meet a volume threshold), have no spread between the price that liquidity takers pay and the rebate that liquidity providers receive. BATS, which has aggressively used pricing as a tool to help build its market, is down to a 1-cent spread for New York Stock Exchange- and Nasdaq-listed stocks.

Indeed, the only market that maintains a 20/30 structure is Nasdaq--as its base pricing tier. For participants that meet its volume threshold, Nasdaq's spread drops to 1 cent per 100 shares, from a dime per round lot. Last fall, NYSE Arca found its dime spread too big for customers and cut it to a nickel. Starting in January, it also began offering high-volume customers a 1-cent transaction-fee spread for Nasdaq-listed securities.

Brendan Caldwell, CEO of Caldwell Investment Management, a Canadian firm with extensive investments in exchange companies around the world, said in November that the Toronto Stock Exchange, for instance, "can run a profitable business not charging anything on the transactions, [but] just charging on the [market] data."

Ratterman of BATS points out that efficient, streamlined U.S. exchanges could probably maintain their business with no transaction-fee spread as long as they hold on to their market data revenue rebates. Many exchanges give a percentage of the tape revenues they receive to the liquidity providers that helped generate that income.

Now, fee competition and the search for a new angle on pricing is prompting some exchanges to incorporate those market data rebates, which are usually doled out quarterly, into the up-front transaction-fee rebates passed on to customers. The ISE Stock Exchange last month switched to a 32/30 structure for all securities. It gives liquidity providers 32 cents but no tape revenue, and charges liquidity takers 30 cents per 100 shares.

"We have been sharing tape revenues since the start of Regulation NMS and have found that in general, [customers] are not as focused on that side of the equation," said Andrew Brenner, head of the ISE Stock Exchange. "By embedding the tape revenues into our maker rebate, it's simplified and transparent for anybody dropping a [fee] calculation into their model." Brenner added that another reason for the change is that knowing what the total rebate will be from the get-go enables some customers to make trading decisions they might otherwise not make.

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