What's an Exchange? PartII: The Real Competitive Advantage-Being an SRO

Equities Exchanges have taken a lot of lumps in recent years, with declining market shares and diminishing respect. But they do have one little-discussed trump card that may ultimately prove their savior:  their own SRO status (and the immunity that comes along with it).

Exchanges have to register as self-regulatory organizations, where each must “enforce compliance by its members, and persons associated with its members, with the federal securities laws and the rules of the exchange.” In return for performing these governmental functions, the SEC has effectively granted them government-like sovereign immunity. As the justifications for exchanges’ immunity have eroded over the past two decades, the consequences for investors--and their competitors--are starting to get pretty steep.

When it permitted exchanges to become profit-oriented firms nearly two decades ago, the SEC effectively opened the door for an entirely new conflict of interest between an exchange’s profit motive and its longstanding SRO responsibilities. For example, would an exchange want to discipline a broker-dealer/member that accounts for a large portion of its revenues or profits? The SEC has never fully addressed this tension. At the time the SEC allowed the switch to for-profit exchanges, it merely stated that there was no “overriding regulatory reason to require exchanges to be not-for-profit membership organizations.”

As for-profit entities, the exchanges and their executives are motivated, and perhaps even obligated, to seek to maximize the value of the enterprises. Most often, this will lead to profit maximization strategies. And exchanges have a number of tools at their disposal to do it. They can charge listing fees, transaction fees, data fees, connectivity fees, and more. They can change their rules and operations in ways that may maximize their profits, such as by creating novel order types or preferences. And while exchanges’ fees and rules are subject to SEC approval, there is little evidence to suggest that the SEC staff has the resources or willingness to meaningfully assess the implications of the five or so they receive each day.

While Nasdaq’s mishandling of the Facebook IPO could have led to a broad rethinking of immunity, it didn’t. Then, on August 26, 2015, a New York judge threw out claims by investors in a far-reaching class action related to high frequency trading. The judge ruled that exchanges are “absolutely immune from suit based on their creation of complex order types and provision of proprietary data feeds, both of which fall within the scope of the quasi-governmental powers delegated to the Exchanges.”

If creating complex order types for traders and selling proprietary data feeds are viewed as “quasi-governmental powers,” and not part of the exchanges’ private for-profit activities, then it seems likely that most activities of the exchanges may fall under this protection. Presumably, this would include, for example, Nasdaq’s controversial new RTFY order type, or NYSE’s new laser connectivity.  Despite the unquestionably profit-based motivation for these activities, it appears as though the exchanges may be immune from any suits arising from them.

But that is not the only conflict-of-interest raised by exchanges’ SRO status. In recent years, the SEC has increasingly relied on the exchanges to develop and implement a number of the SEC’s regulatory initiatives that could have dramatic impacts on the exchanges’ bottom lines.  For example, the exchanges have been tasked with developing the Consolidated Audit Trail. This undertaking is unquestionably a regulatory responsibility. But it will equally unquestionably impact the exchanges’ revenues and profitability. Who will pay for its construction and operation? Will they decide to shift the costs over to broker-dealers and ATSs? How? How will it be governed? The answers to these questions may have dramatic impacts on not only the speed of the CAT project and its ultimate efficacy, but also on the exchanges’ own profitability--and those of their competitors.  

While the conflict-of-interest between exchanges’ SRO responsibilities and their profit-oriented businesses has expanded, the justification for their SRO status has significantly diminished.  

Historically, when trading on a listing exchange served as an effective monopoly over trading in a security, the exchange was well positioned to monitor trading for abuses. That simply isn’t the case anymore. Now, trading is diffused across hundreds of broker-dealer internalizers, dozens of ATSs, and numerous exchanges. It would make little sense for each exchange to conduct surveillance on its venue without input from all other venues. Nor is it practical from a cost perspective for an exchange to develop its own surveillance mechanisms. In fact, cost-conscious exchanges have increasingly outsourced most of their SRO responsibilities to yet another SRO (FINRA). Thus, while exchanges remain responsible for performing oversight, they don’t actually do much themselves.

What does all this mean? To market participants, exchanges and ATSs are largely fungible in all but one way: when they are wronged by an ATS, they can recover from it, but when they are wronged by an exchange, they most likely can’t.

While current SEC Commissioner Stein and former Commissioner Gallagher called on the SEC to reconsider the SRO model well-before the Barclays decision heightened the urgency of that review, we haven’t seen any action yet. The issue does not appear on the SEC regulatory agenda nor does it appear to be anywhere on the radar screen. Maybe it’s time for that to change.


What is an Exchange?

This is the first article in our “What’s an Exchange?” series about the role of exchanges in the modern market structure. It seems like a simple question, but it seems to be getting harder and harder to answer. Exchanges used to be member-owned market centers with relatively effective monopolies over the trading of securities listed on them. They had regulatory obligations over their listed firms, as well as the trading that occurred on them. Profits were not a traditional focus, since they came at expense of their members. Revenues largely came from transaction and market-data fees, and to a lesser extent, listing fees.

Fast-forward to today and exchanges are now for-profit entities owned by independent third parties and in many cases publicly traded on the very exchange they oversee. The monopolies are largely gone, and they have largely outsourced their regulatory obligations to a single third-party service provider, namely FINRA. As for how they make their money, trading revenues have declined in relative importance as exchanges are increasingly relying on sales of proprietary data products and access (e.g., co-location), as well as their SIP fees.

In many ways, exchanges face more competition than ever before. Dark pools, other exchanges, and an increasing number of internalizers are siphoning off their trading volumes at a record pace. Exchanges’ roles in our market structure have devolved so much so in recent years that when the SEC put together its Equity Market Structure Advisory Committee last year, it didn’t even bother to include either of the longtime dominant exchanges in the US: NYSE and Nasdaq (an omission that we and others have recommended be remedied).

In an effort to restore their market share and role in the markets, exchanges have been looking to aggressively expand and diversify. As we will explore in subsequent articles, this has led to a dizzying array of efforts to increase data products and access revenues, as well as efforts to obtain exclusive listings.

Today’s article focuses on one potential revenue generator for exchanges—competing more directly with brokers.

Blurred Lines: Exchanges Eye Broker-Like Roles

It would have been unfathomable just a few years ago to think that an exchange – which was then owned by its broker/members – would seek to compete with brokers for order routing services. Yet, that may be a world in which we’re entering.

The SEC has long restricted exchanges’ relationships with their members. The Commission recently re-articulated that these restrictions arise, in part, from “concerns [about] unfair competitive advantages that the affiliated member could have by virtue of informational or operational advantages or the ability to receive preferential treatment.”  The Commission has also been concerned that exchanges could put their commercial interests ahead of their SRO obligations.

While restricting affiliations with exchange members, the SEC has allowed exchanges to take on broker-like responsibilities in small but progressive filings. Most notably, in recent years, exchanges and other market centers have be allowed to offer increasingly complex order types and functionality that include detailed order routing and preferencing characteristics.

In the last few months, the expansion of exchange’s activities into what we might traditionally think of as “broker” turf has stepped up…dramatically. Just last month, the SEC approved a Nasdaq proposal to expand Nasdaq’s order routing capabilities and responsibilities for retail orders. Nasdaq dubbed the order routing mechanism RTFY. Nasdaq argues RTFY would “enhance execution quality and benefit retail investors by providing price improvement opportunities.”

Essentially, Nasdaq has proposed (and subsequently received approval) to route retail orders to “market makers” of its own volition. What’s more, Nasdaq can receive Payment for Order-flow “PFOF” on the orders from those “market makers.” The customer orders who are routed out would receive some level of “price improvement” versus the exchange’s prevailing quote, and Nasdaq would have a Best Execution Committee to oversee the process. If this sounds to you a lot like how large retail broker-dealers currently handle their customers’ orders, it does to us too.

Evidently, Nasdaq was frustrated that it keeps losing retail order flow, as retail broker dealers came to route these orders directly to wholesale market makers. Nasdaq wants a piece of the action;  And we can’t blame them. PFOF isn’t chump change.  For example, in 2014, TD Ameritrade disclosed receiving payments of $230 million in 2013.  Of course, this gives rise to a direct conflict of interest of whether the broker should route to the venue that is best for the customer, or the venue (or market maker) who pays it the most. Unfortunately, investors’ fears of this conflict were not assuaged by TD Ameritrade’s admission in a Senate hearing that it always routed orders to the venues that pay the highest rebate.

But this is different.  Nasdaq is an exchange.  So aside from these concerns, we also have a few questions about how this routing functionality works for an exchange:

  • How and to what extent would Nasdaq comply with both the Commission’s rules as well as FINRA’s expectations for best execution, most importantly, its recent guidance?
  • What rules-based process would Nasdaq use to select market makers, and how would it ensure that the process is non-discriminatory?

  • Is the market maker selection process sufficiently transparent so that investors and routing brokers understand the handling and treatment of their orders?

  • Would investors and routing brokers be aware of the existence and relative magnitudes of conflicts of interest, such as payments or other agreements wherein the exchange receives some benefit in return for routing orders to a particular market maker or market makers?

  • Will these functions be exempt from Rule 606 reporting, and if so, what about these orders justifies the exclusion?  

  • What disclosure, if any, surrounding the routing of RTFY orders would be publicly available to allow broker/dealers to meaningfully evaluate execution quality and whether they should utilize the order-type or venue?

  • What disclosures would Nasdaq make that would allow for ready comparisons of execution quality across different market venues?

  • How will Nasdaq ensure that no informational advantage is given to the market makers through this process?

  • Would the market makers be positioned to disadvantage customers with resting orders on Nasdaq or other market centers?

  • Given the exchanges’ preferential legal status as self-regulatory organizations, what is the recourse if an order, or set of orders, receives poor quality execution or processes aren’t appropriately disclosed or followed?

  • How would the Best Execution Committee function while burdened by both a non-discriminatory mandate of an exchange and a discriminatory one (of a broker-dealer bound by best-execution obligations)?

  • What rules-based process would be established to ensure that the Best Execution committee would fulfill its broker-dealer-like responsibilities, and how is this dissimilar from broker-dealers’ Best Execution committees?

  • How often would Nasdaq’s Best Execution committee meet and how with it operate?

  • Does this routing functionality simply allow Nasdaq to participate in the highly controversial retail payment for order flow model?

  • How is this functionality consistent with the underlying purposes of Rule 612, which prohibits exchanges from accepting sub-penny orders?

  • While this order routing functionality is currently restricted to retail orders, could it be expanded for institutional-sized orders? If not, why not?

Interestingly, while Nasdaq is looking to expand its broker-like order routing powers, NYSE has been going in the opposite direction. For example, NYSE recently filed and received approval to eliminate Good Till Cancelled and Stop Orders. In the filing citing among other things, NYSE cites that “eliminating GTC Orders would benefit investors because it shifts the responsibility to monitor best execution obligations on behalf of a customer to the member organization entering the order, rather than leaving a GTC order at the Exchange until it gets executed.” In other words, NYSE is saying the duty of Best Execution is the responsibility of the broker, whereas Nasdaq is taking on the Best Execution burden.

Whether you think this is “fair” or not may depend upon your perspective. On the one hand, exchanges expanding into brokers’ roles could be viewed as simply leveling the playing field. Brokers have been able to take a whack at their revenue streams with ATSs, payment for order flow, and internalization, so why not let exchanges do the same thing?  On the other hand, exchanges still have far different regulatory status than brokers. They have SRO responsibilities.  They have immunity.  They have different order handling and reporting obligations.

In our view, regulators have yet to really focus on the broader issues raised by this blurring of the lines, and we’re likely years away from any comprehensive review or assessment. That said, as we continue down this road, we hope that investors and regulators will begin to focus on some of the significant transparency concerns and non-trivial conflicts of interest raised by these actions. While each of these options may give rise to some benefits for some traders, they may come with significant costs to market transparency, fairness, and efficiency.