Commentary: The Trouble with Access Fees
Traders Magazine Online News, July 20, 2010
With the institution of Regulation NMS in 2007, the Securities and Exchange Commission must have believed the problem of access fees had been solved once and for all. But, like the undead zombie feared by Voodoo practitioners, the issue of access fees has arisen once again, this time to frustrate the SEC's efforts to eliminate flash orders.
Access fees originated in the world of Electronic Communications Networks, or ECNs, which in reality are electronic stock exchanges. Under the Securities Exchange Act of 1934, national securities exchanges are required to be self-regulatory organizations (SROs), a function that magnifies the cost of operating any stock exchange. The costs of maintaining SRO function were a barrier to entry that would have prevented the fledgling ECNs arising in the late 1980s from competing with the New York and American Stock Exchanges, as well as with Nasdaq, which at the time was regulated as a "securities information processor."
The SEC believed that ECNs offered an innovative alternative to the floor-based models of the New York and American Stock Exchanges and to the market maker business model employed by Nasdaq. So, the SEC allowed ECNs to register as broker-dealers, but granted them a host of exceptions because many broker-dealer regulations made no sense when applied to the stock exchange business. Eventually, ECNs and other variations on the electronic stock exchange theme became known as "Alternative Trading Systems" and the exceptions to broker-dealer regulations were refined and codified as Regulation ATS. Technically, an ATS is a broker-dealer operating under the exceptions enshrined in Regulation ATS. An ATS that cannot satisfy the conditions of Regulation ATS must register as a national securities exchange.
ECNs originally operated as closed systems. Only subscribers were permitted to post or take quotations, and subscriber agreements established a transaction-based fee schedule. In that sense, the ECN business model was similar to stock exchanges, which also charged transaction-based fees. But, there was one big difference. Stock exchange membership was limited to broker-dealer members. ECNs were open to members of the public, and most importantly, to institutional investors who otherwise were required to access public liquidity through broker-dealer members of the various registered exchanges.
Broker-dealers soon discovered that ECNs were a convenient way to display and access institutional liquidity at prices that improved the quotations displayed in exchanges. As a result, something of a two-tier market developed, with institutional and broker-dealer orders being displayed in ECNs at prices that were superior to those displayed in the public markets. Retail order flow generally did not have access to the ECN prices. The SEC views two-tier markets as inconsistent with the objectives of the Exchange Act. Therefore, it eventually required broker-dealers to provide the same quotes in the public markets that they displayed in ECNs.
To avoid losing the broker-dealer business, most ECNs began displaying their quotations in the public markets and provided their broker-dealer clients with useful systems tools that enabled them to provide consistent quotations in ECNs and public markets. However, this also meant that, for the first time, quotations in ECNs could be accessed by broker-dealers that were not subscribers. Broker-dealers, of course, will not pay for anything that can be obtained for free. ECNs responded by sending bills to broker-dealers that accessed the ECN quotations in public venues, and when some large broker-dealers refused to pay, interesting litigation commenced.
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