In this recent research note, Sandler O’Neill + Partners, L.P. Principal Richard Repetto examines why the public exchange operators hold multiple licenses and that rationale behind this phenomenon.
Here is the note in its entirety:
The three largest equity exchanges own/control 12 exchange licenses. The CBOE, ICE and Nasdaq own collectively 12 exchange licenses or “medallions” as they are referred to. Some have speculated they have chosen not to consolidate these exchanges/licenses in order to gain more market data and connectivity fees. We disagree. We believe the reason why they own multiple medallions is mostly driven by SEC regulation/rules and to give customers choice. This note outlines three reasons why the large exchanges maintain multiple exchange licenses/medallions.
First, the SEC has mandated exchanges treat all customers the same. Said another way, each exchange medallion must have a similar structure or market model and treat customers in a similar manner (not segment customers). For example, the normal execution prioritization structure is called PRICE TIME where if you are equal to the best price, your order is prioritized based on the TIME it was placed. In other words, if the best bid is $10, and you place a bid order for $10 at 10:00 am, and another bid order is placed on the exchange for $10 at 10:05 or after your order arrives, the first order will get prioritized/executed first. Seems fair right? … This is the way the vast majority of exchanges models work with “PRICE TIME” priority. But there are different market models, which we discuss below.
There is another prioritization structure called “PRICE SIZE”. So as long as you are equal to best price, your order is prioritized based on the SIZE of your order. In other words, if the best bid is $10, then if you place a bid order for $10 for 100 shares at 10:00 am, and then another order comes in at 10:05 am after yours with a $10 bid for 1,000 shares, the 1,000 share order would get executed/prioritized first. Time doesnt matter in this structure, but the size of your order does. Certain large institutional customers, who want to move size, like this structure.
And there are different pricing structures or market models. There’s the popular maker taker market model where the taker of liquidity pays the execution charge and the provider of liquidity gets a rebate. This is the market model most exchanges use. In contrast, theres also what is called an inverted model where the taker of liquidity gets a rebate and the provider or maker of liquidity gets charged (i.e. the reverse of the maker taker model). This sounds strange but in certain circumstances traders are willing to pay to have liquidity removed against them. Bottomline, the first reason why exchanges own multiple medallions is because of the SEC, who mandates that the exchanges must treat customers the same (i.e. not make aspects of the market model available to some and not available to others) and in just rare exceptions allowed different exchange market models or customer segmentation within a single exchange license/medallion.
Exchange Medallions and Pricing Models/Differentiators
A second reason for exchanges to maintain multiple medallions is that the order protection rule (OPR) only protects the top buy/sell order of each exchange (medallion). Therefore, if you have multiple exchanges, customers have multiple chances for their customers (sometimes segmented by customer type) to be at the top of book (or the front of the line) and be protected by the OPR increasing the likelihood their order may get executed. Again, the OPR is borne out of the SECs Reg NMS established in 2005. Note: the NYSE even proposed a 1% minimum market share threshold for exchange quotes to be protected back in a draft proposal in 2014, which would have reduced fragmentation or the number of exchanges with protected quotes. Today, if there was a 1% threshold to apply the OPR, it would eliminate 3 of the 5 NYSE exchange medallions, given their current market share (under this proposal 1 of Nasdaq’s and 1 of CBOE’s medallions would also not be allowed protected quotes).
And a third reason has been listing standards. Listing standards can vary by exchange. The NYSE is known for its high listing standards and attracts a certain type of customer (issuer). Contrast that to the NYSE American, which has predominantly been a small cap listing venue. NYSE Arca and CBOEs BZX have become homes for ETF listings (partially because of liquidity provider programs offered at these venues). We suspect the SEC would like to maintain a balance by not lowering listing standards at the NYSE but not having listing standards so high at the exchanges that cater to small companies that could prevent them from coming public.
