Between market data, consolidation and competition, market-making/market-taking, the Transaction Fee Pilot and the SIPs, 2019 was an eventful year. So to set the stage for what’s ahead in 2020, here’s a roundup of the most important topics in U.S. equity market structure in 2019.
1. Market Data Wars
Market data is a high-stakes issue: it makes up a very significant share of revenue for most exchange operators. 2019 was particularly eventful on this front. Specifically, the standard that exchange fee filings must meet to demonstrate consistency with the Exchange Act is undergoing a de facto redefinition. At the end of 2019, the outcome remains unclear.
A late 2018 SEC legal opinion was an important catalyst for the developments of 2019. In it, the SEC reaffirmed the standard it had described in 2008 for exchange fee filings and concluded that NYSE and Nasdaq had not met this standard for the data fees under scrutiny. NYSE and Nasdaq each appealed the SEC’s decision to the DC Circuit Court. The two cases were consolidated and briefing took place in the first half of 2019. (Full disclosure: IEX wrote an amicus brief in support of the SEC.) Oral arguments are scheduled for February 18, 2020.
At the heart of the 2008 standard is the idea that an exchange can justify a fee filing by demonstrating that the proposed fee is constrained by competitive forces. This approach is reminiscent of competition economics, except that the burden of proof is reversed. Here the exchanges must demonstrate the presence of competition, whereas a typical antitrust argument must demonstrate a lack of competition.
In May 2019, the SEC Division of Trading and Markets published staff guidance on exchange fee filings. In it, the competition economics approach is reaffirmed but somewhat narrowed. Presence of competition can be used to justify “reasonableness” of the proposed fees. However, separate arguments must be made to justify “equitable allocation,” “no unfair discrimination” and “no unnecessary burden on competition”. The additional clarity was a step in the right direction. However, in June 2019, SEC Chairman Jay Clayton issued a short public statement which stressed that “[l]ike all staff guidance, the TM Staff Guidance has no legal force or effect,” taking back some of that clarity.
These developments are taking place in the shadow of recent developments in competition economics outside the world of market structure. The Supreme Court’s 2018 decision in Ohio v. American Express was widely regarded as a validation of the “multi-sided platform theory” approach to competition economics. Under platform theory, traditional signs of competitive failure, such as sub-cost or even negative prices, can be compatible with a competitive environment. Unsurprisingly, exchange operators have tried to reframe the market data debate to justify their fees under this everything-can-be-competitive theory.
With the backdrop of these legal and regulatory developments, the pace of market data fee filings by exchange operators has notably slowed. This pause likely reflects the time needed to adjust to the new regulatory environment and is likely to not last much longer. IEX followed the structure of the Staff Guidance closely in an August fee filing. Expect much more in 2020.
2. Consolidation and Competition
Like market data, consolidation continues to be one of the most important topics in U.S. equities market structure.
On the institutional agency side of the industry, the tiered exchange rebate system incentivizes consolidation of institutional order flow under a handful of large sponsor MPIDs. On the retail agency side, five firms reportedly split the wholesale market. On the principal trading side of the industry, several years of consolidation among proprietary trading firms have led to a few firms representing a large proportion of the principal order flow.
Beyond the general concerns associated to industries where market power is concentrated among a few large firms, consolidation in U.S. equities raises unique questions such as the impact on price formation or financial stability. (These questions strike me as important questions that deserve additional scrutiny in the academic literature and elsewhere.)
Topics of competition economics relevant for the U.S. equities industry are not limited to consolidation. For example, they also take center stage in the market data wars (see previous section). The increasing importance of competition topics was noted in a late 2018 speech by SEC Commissioner Robert Jackson. Jackson called for the creation of an Office of Competition Economics within the SEC’s Division of Economic Risk and Analysis. But note that in a November 2019 speech, SEC Chairman Jay Clayton described his view that antitrust policy and enforcement are the exclusive domain of the DOJ and FTC. On the other hand, other agencies are typically reluctant to take up topics that can reasonably be considered to fall under the jurisdiction of the SEC. Given all this, I hope to see the SEC build up its competition expertise in 2020.
3. Make/Take Races and Liquidity Provision
“Market-maker v. market-taker” was very much in focus in 2019. This expression refers to the difference, among HFT strategies, between strategies based on bona-fide liquidity provision (making), and strategies based on seizing arbitrage opportunities using spread-crossing orders (taking).
At the micro scale, the market-maker v. market-taker story plays out in millions of make/take races every day. A make/take race is a microsecond-timescale event in which HFT market participants suddenly agree that the price of a given security has changed because they all observe the same external event, such as a price change in a correlated security. Takers race to trade with orders that are resting at a newly stale price, and makers race to cancel their outstanding limit orders before they are traded against. At the macro scale, the market-maker v. market-taker story raises questions about price formation, the incentives to make markets, the value of displayed limit orders, and ultimately market design.
In the academic literature, this nuanced perspective on HFT is somewhat recent and an evolution over an older literature that studied “HFT” as a whole. There are now a number of papers that study the market-maker v. market-taker phenomenon. Similarly, the topic is being discussed in industry publications and blogs. There is no universal agreement on the relative value of market-makers v. market-takers. Some view both as inseparable and equally contributing to price formation. Still, there is a broad and diverse consensus around the idea that market-making plays a privileged role because of the positive externalities that displayed quotes create in the market. The SEC itself has long defended the value of displayed quotes in the National Market System.
Exchanges are not standing still. In June, EDGA submitted a rule filing proposal to subject all spread-crossing orders to a 4-millisecond delay. This proposal effectively gives a 4-millisecond head start to makers against takers in make/take races — an “asymmetric speedbump”. Unsurprisingly, HFT firms usually associated with market-taking wrote comment letters against the proposal, and firms usually associated with market-making wrote comment letters in favor of the proposal. A number of non-HFT firms wrote comment letters against the proposal, on the ground that an asymmetric speedbump is narrowly tailored to benefit a class of HFT strategies against another, as opposed to being available to a broad spectrum of HFT and non-HFT firms engaging in liquidity provision. The SEC will decide whether to approve or disapprove the EDGA proposal in 2020.
In turn, IEX very recently submitted a rule filing proposal to offer a displayed limit order type (called D-Limit) that would automatically be repriced back when the IEX system (via the IEX Signal) predicts the price is very likely to retreat. These events are exactly the make/take races described above. While HFT market-makers have a chance to win make/take races, non-HFT firms resting limit orders have basically zero chance to do so and suffer terrible performance in these fleeting moments on average. By offering D-Limit, IEX intends to provide a tool which promotes the use of displayed limit orders by all firms, HFT or non-HFT alike. The SEC approval process will also take place in 2020.
4. Rebates and the Transaction Fee Pilot
The use of rebates — per-transaction payments by an exchange to a customer — has been controversial since the creation of this model, over twenty years ago. The more general topic of payment for order flow, and its interaction with the fiduciary duties of agents directing their customers’ orders, has been controversial for much longer. On the one hand, there is a relatively broad consensus around the potential conflicts of interest and harmful complexity that rebates create. On the other hand, there is disagreement about the benefits that rebates bring in terms of supporting liquidity provision and market quality.
In the final days of 2018, the SEC adopted a rule to run a pilot study to clear up this area of disagreement. The study, called the Transaction Fee Pilot (TFP), is a randomized controlled trial — arguably the best possible design for quantitative causal studies. Around 20% of equity securities are to be drawn at random and placed in two test groups (10% in each). In the first test group, transaction fees will be capped at 10 cents by 100 shares. In the second test group, rebates will be prohibited. The remaining 80% of equity securities will serve as the control group. The TFP is a temporary data gathering exercise. By comparing the test groups and the control group, the TFP will measure the benefits, if any, that rebates bring in terms of supporting liquidity provision and market quality.
In February 2019, NYSE, Nasdaq, and Cboe surprised the industry by suing the SEC to block the TFP in the DC Circuit Court. The SEC suspended the TFP while the case was progressing in court. Briefing was completed over the summer. Notably, the three largest NYSE DMMs (Citadel, GTS and IMC) wrote an amicus brief supporting the exchanges’ action. (Full disclosure: IEX wrote an amicus brief in support of the TFP. So did ICI/CII, Better Markets and RBC.) Oral arguments were held in October 2019. The case raises issues that go beyond the securities industry context, such as whether an administration has authority to run data-gathering experiments (I really hope the answer to that one is yes!) and what a cost-benefit analysis means for such experiments. The court’s decision is expected in early 2020.
Like market data, rebates and the boundaries of SEC’s authority are both high-stakes issues. The importance of the TFP litigation cannot be overstated.
5. Spotlight on the SIPs
In 2019, there were a lot of ideas to improve the SIPs, and some action. Coincidentally, the CTA SIP suffered a rare failure which meaningfully disrupted trading on August 12.
In terms of data content of the SIP feeds, the SIP Plans proposed to add odd-lot top of books to the feeds, without changing the protected NBBO. Many commenters proposed to go further and decrease the round lot size for some classes of securities. Another common idea is to add some depth-of-book information to the SIP feeds.
In terms of their speed, the SIP feeds are currently limited by geography because the data must travel through a unique point of consolidation on its way from the source exchange to the data consumer. Exchange proprietary feeds travel directly from the source to the consumer. As part of a broader competing market data aggregators (CMDA) idea, SIFMA has proposed a distributed model where SIP providers would offer local NBBO views in proximity to various exchange data centers. The CMDA proposal is broader in that it includes opening the currently monopolistic SIP operations up to competition.
There also were developments regarding the SIPs’ operating structure. In September, a coalition of industry participants petitioned the SEC for additional transparency in SIP costs and revenues. In October, the SEC proposed a rule to rescind the effective-upon-filing procedure that applies to the fee changes of all NMS Plans, including the SIP ones. SIP governance was part of a long list of potential areas of reform list in a March speech by SEC Chairman Jay Clayton and Division of Trading and Markets Director Brett Redfearn, along with several of the topics listed above.
“Market Data Distribution and Market Access” is part of the Fall 2019 Reg Flex agenda. Chairman Clayton has indicated several times that he was taking the Reg Flex agenda setting process seriously. Many in the industry expect to see some regulatory action around SIPs in early 2020.
Also notable in 2019:
– Evolving retail market. In June, IEX announced a retail program that systematically offers half-spread price improvement to retail orders. In October, all major online brokers cut fees to zero over the course of a couple of weeks. In November, Schwab and TD Ameritrade announced that they would merge. In November, Robinhood was planning to maintain their PFOF business model for a 2020 entry in the UK market. This would test the regulatory framework around best execution in the UK, where there is currently no PFOF. In the meantime, Robinhood settled with FINRA for best execution violations related to PFOF in the U.S.
– Best execution. The Robinhood settlement mentioned above was also notable as a rare example of a FINRA best execution enforcement action.
– CAT. Exchanges replaced Thesys with FINRA to build the CAT.
– More protected quotes. 2020 could see the number of exchanges go from 13 to 16.
– Europe. The effects of MiFID II are still working their way into Europe’s market structure. Many lessons learned in Europe, particularly around a number of market structure innovations, are potentially relevant for the U.S. Some topics of interest include the rise of bilateral trading, a dynamic tick size regime, periodic auctions, the disappearance of rebates and the non-emergence of a commercial consolidated tape offering.
– Private markets. Direct listings received increasing attention after successful instances by Spotify in 2018 and Slack in 2019, both on NYSE. Citadel Securities, the DMM in both cases, featured prominently in many press articles on the topic. In June, the SEC published a Concept Release on Harmonization of Securities Offering Exemptions. So far, the concept release received 167 comment letters. A few private markets are already in operation (with various complex structures), and more are expected to launch in the near future. In December, the SEC proposed a rule that would expand the definition of “Accredited Investor.”
– True 2019 stories. Trucks. Real chicken sandwiches. Fake chicken sandwiches. Elon Tusk and Tim Apple. Infinite leverage. Profits and Losses. Spies. “Death.” Pro. La Grande Évasion. Hard seltzers. And lots of tequila shots.
If you have further thoughts — or think I missed something! — don’t hesitate to reach out at email@example.com.
 This “competition” line of argument is not the only path to demonstrating consistency with the Exchange Act.
 For example, Nasdaq now Chief Economist Phil Mackintosh wrote in a prior role in 2017: “But there are more reasons to eliminate rebates. Note that we’re not arguing to keep rebates. We think they also: (1) Add to fragmentation, by supporting venues based on fee structures — something the tick pilot is already proving. (2) Make the market more complex, adding to the need for new order types, increased message traffic and over-quoting.” (Venue Analysis: Are you missing half the story?, May 17, 2017)
 The Wall Street Journal wrote: “In an unprecedented legal confrontation, the three biggest U.S. stock-exchange groups are taking on their own regulator to block an initiative that seeks to limit the fees they can charge for trading.”
 An audio transcript file of the hearings can be found here.
 And potentially around market data more generally — see remarks by SEC Commissioner Robert Jackson in SEC’s Jackson ‘Confident’ Commission Will Get Exchange Fee Data, Bloomberg News, 12/05/2019.
 Indeed some first steps were taken after this blog was written.