One part of the SEC's Regulation NMS proposals often takes a back seat when the debate is about trade-through reform. But don't be fooled: The market data component is as far-reaching and controversial as the widely-reported trade-through recommendations.
"This SEC proposal is simply attacking the wrong side of the problem by trying to figure out how to divvy up the pie of market-data revenues," says Lawrence Leibowitz, co-head and executive vice president of Schwab Soundview Capital Markets, the institutional research and trading arm of the Charles Schwab Corp. "The problem is that the pie is too large."
Reg NMS, published by the Securities and Exchange Commission in late February, is an attempt to modernize the national market system. It is regarded as the commission's most sweeping overhaul of the equities market structure since the Securities Act Amendments of 1975. Reg NMS reportedly took many years of painstaking work before the final document was released earlier this year.
Reg NMS tackles four critical areas: the trade-through rule, market access fees, subpenny pricing and market data. The creation of a uniform trade-through rule has made headlines. That's largely because it potentially threatens the dominance of the New York Stock Exchange and other traditional markets.
Nevertheless, the market data proposal is also significant because hundreds of millions of dollars are at stake. In 2003, for instance, the government-sponsored networks that collect market-data fees brought in $424 million in revenues. Expenses for consolidating and disseminating trade and quotation data totaled $38 million.
The New York Stock Exchange got the biggest share of the market data pie: $148 million. NASD and Nasdaq captured $116 million. The rest was divvied up among the remaining self-regulatory organizations, based on their reported trade or share volumes.
Reg NMS makes a number of market data recommendations. It continues the SEC's commitment to providing consolidated information to market participants, but at a lower and more cost-related price. It reduces the scope of the consolidated data that would be provided to broker dealers and other recipients.
Market Center
Under the proposal, the data would include the price, size and market center of the national best bid and offer and last-sale information. The current required provision of a montage of quotes would be eliminated. The market data proposal would allow market centers to independently price and sell market data that falls outside the definition of "core information."
Finally, the proposal recommends a new formula for determining how market-data revenues are allocated to the SROs. This formula, much more complex than the current simpler one, would reward markets for providing more aggressive, better-quality quotes that create greater price transparency. The formula, which includes an infamous square root, was also devised with an eye toward eliminating the current monetary incentives for wash trades and other practices. These create what the SEC calls "serious economic and regulatory distortions" in the market.
So far, the formula is the only aspect of the market-data proposal that has generated consensus. "We all had different opinions about what the world should look like, but we all agreed that the revenue-sharing formula should not be what the SEC has proposed," says Adena Friedman, executive vice president of corporate strategy and data products at Nasdaq. She was referring to a panel of industry executives that discussed the topic of market data at the SEC's mid-April NMS hearings in New York.
"The SEC had the right intention – trying to create a calculation that couldn't be gamed," says Jodi Burns, an analyst in the securities and investments practice at Celent Communications.
"But it's a monster of a calculation, it's not transparent, and plenty of firms will spend time thinking about trading behaviors that will increase their share of market-data revenues," she adds.
While the formula has few fans, there is also criticism in other areas. Schwab has been a persistent critic of what it sees as discriminatory and unfair practices involving market-data fees.
For years, the firm has argued that the fees charged are monopolistic and too high, particularly since the orders of brokerages provide much of the liquidity in the markets. The lack of cost transparency is another complaint.
"Clearly too much is being charged for market data," says Schwab's Leibowitz. "You can tell that because all these exchanges are paying for their regulatory functions by using market-data revenues, and there's enough left over for everybody to talk about how to share all the spoils."
Leibowitz suggests that in a perfect world, the SEC would not be regulating fees, although that's not currently a viable option. He argues that the SEC must force the fees down drastically. NYSE's OpenBook product, which shows full depth of book in its market, should also be available to all investors at a reasonable cost, he noted.
Gene Finn, a former SEC and NASD economist, points out that under the NYSE's and Nasdaq's administration of the networks that process market data, discriminatory "non-professional" fees imposed on online investors have been "obscenely excessive." Moreover, they have resulted in "obscenely exorbitant compensation for the top officers of the SROs," he says.
Alex Goor, president of the INET ATS, contends that neither the NYSE nor Nasdaq is prepared to give up its monopoly over market data despite their public support of competition.
"The NYSE uses that information to sell seats," he says. "It reveals almost no data about its full depth of book, but it gives a lot of data to people who are on the floor. That's why people pay millions of dollars to be NYSE members." The INET ATS was formed earlier this year through the consolidation of the Instinet ECN and Island ECN. Officials of the NYSE were not available for comment.
Celent's Burns notes that Reg NMS doesn't fundamentally change where market-data revenues go. Left unanswered in the SEC's proposal is who owns the market data and what role do the member firms of the exchanges have in producing the data. "The SEC seems to be continuing to give the exchanges almost the sole right to distribute the data," Burns says.
Burns highlights another message sent to exchanges. "It's that market data is a viable business model for exchanges to follow in creating additional revenues," she notes. "Allowing the exchanges to distribute their own data directly to data vendors encourages them to come up with unique data products as a new source of revenue."
Burns sees this as an interesting development that will likely lead to useful, value-added products. At the same time, Burns wonders whether the SEC is implicitly recognizing the "lack of profitability associated with trading right now."
While the SEC's proposal advocates opening up market data to some competitive market forces, Nasdaq is asking the SEC to go further. Nasdaq makes the case that the NBBO should be the only consolidated data disseminated through the securities information processor, or SIP. Instead of charging professional investors $20 per month for the current mandated consolidated information, Nasdaq would provide what it deems "public-good information" – that is, the NBBO for Nasdaq stocks – for $5-7 per month, which is a closer reflection of its real cost.
All other data, including last-sale information and depth of book, would be sold on a proprietary basis. The rates would be determined by market forces.
Schwab, and others in favor of lower prices and more competition, praised this proposal at the NMS hearings. Yet they noted that it created the potential for a two-tiered system, a system in which investors with the minimum required information would not necessarily have sufficient data with which to make informed investment decisions.
Nasdaq's Friedman responds that competition and not government monopolies – should determine where exactly the value lies. She adds that investors who want more than Nasdaq's basic Level I data can already choose to pay more for Level II data, which includes full depth of book. However, she also acknowledges that the ranks of non-professional investors who subscribe to Nasdaq's Level II product have increased from about 50,000 to 100,000 over the last several years. That indicates the importance of having a fuller array of information.
Schwab's Leibowitz insists that the needs of investors are paramount. "In a decimal world, you've got to know more than the top of the book," he says. "When we went from 1/8th or 1/16th increments to pennies, it became very important to know things below the top of the book because there's very little liquidity at the top of the book."
Leibowitz recognizes that it costs more to collect and disseminate depth of book. "But that should be a right, not something that people have to pay for and that profits an exchange," he says.
Finn, the former SEC economist, goes further. He says there should be no charge to small, individual investors for real-time BBO and real-time last-sale data for listed and Nasdaq stocks because they need that information to monitor their trade executions. He calls the SEC's proposal to eliminate the current anti-competitive constraints on market participants selling their own quotes and market trade data, "a step in the right direction."
According to Nasdaq's Friedman, last-sale data, while important, does not rise to the level of public-good data since "it's a reflection of what happened in the past, not what's currently available in the present." Another reason she cites for excluding the data is competition. "As more regional exchanges have started to report that information, because through their own economics they have become print shops, we've found some quality issues with last-sale data," she explains. "Competition will make it a higher-quality product."
INET's Goor disagrees. He believes that Nasdaq is betting that it will be able to effectively keep its monopoly in a competitive landscape. How? By laying claim to the existing wires and built-in infrastructure that currently belong to the SIP.
"Nasdaq is the SIP right now, and the SIP has the infrastructure," Goor says. "But the SIP is a public good that's being administered by a conflicted entity." He says that this gives Nasdaq an unfair advantage since broker dealers and others are already used to going to Nasdaq's distribution system.
Distribution
Goor argues that either Nasdaq should have to cede its distribution network or carry whatever information other marketplaces wish to send along with the public-good data.
"Nasdaq is proposing to reduce market-data fees. They think they'll be able to charge more for the feeds they own based on the fact that they've been administering this public good," he said. He points out that INET is willing to provide full depth of book at no charge. "My point is you shouldn't underestimate the logistical challenges of competing with a built-in-infrastructure," Goor says.