Have lawmakers given U.S. exchanges carte blanche to charge whatever they want for distributing market data to their members?
If so, what will that mean to the U.S. financial industry, which lives and dies on such details of prices and volumes on millions of trades, to clear and settle transactions as well as determine next moves?
Those are the questions now at the center of a debate brewing for four years and now brought to the fore by the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in July.
The issue: whether U.S. exchanges can charge “market prices” for their data – i.e., whatever the market will bear – or whether there must be some relationship in the price to the underlying cost of delivering the data. And whether wording in the Dodd-Frank Wall Street Reform Act supports that position.
The answer, which will affect the bottom lines of brokers, market data vendors, high-frequency traders and investors is based on a claim made by NYSE Arca, the electronic trading network operated by NYSE Euronext.
The NYSE Arca applied in 2006 to the SEC to charge fees for firms to access its proprietary "depth of book product" known as ArcaBook. This book lists pending orders on NYSE Arca.
In its application, NYSE Arca claimed that it should charge “market-based pricing” for its proprietary market data because there is enough competition with other trading venues in delivering market data that will prevent it from setting fees which are too high.
Such “market-based pricing” is a departure. NYSE Arca, like other electronic communication networks that started in the late 1990s, gave away its market data as a carrot to draw liquidity. In 2005, the network, known at the time as Archipelago, was bought by the NYSE.
Now, Nasdaq OMX Group, which operates the Nasdaq Stock Market, is using the same argument in its application to the SEC last month about charging for its depth of book data. "Broker-dealers currently have numerous alternative venues for their order flow, including ten self-regulatory organization (SRO) markets, as well as internalizing broker-dealers and various forms of alternative trading systems including dark pools and electronic communication networks," says the exchange.
Despite differences in pricing models, market data vendors such as Bloomberg and Thomson Reuters as well as Internet portals such as Yahoo also can enforce "pricing discipline" -- they can simply refuse to purchase any proprietary data product that does not provide value. That means Nasdaq and other producers of proprietary data products don't have it easy. They have to understand varying business models and pricing disciplines to market proprietary data products.
The proprietary non-core data – otherwise known as depth of book data -- is information about bids and offers inferior to the best prices that exist in equity exchanges. Such data is used by brokers and others to measure the supply and demand for a security and determine where to route their orders. By contrast, exchanges also provide consolidated data, includes the last sale price for a security, each exchange’s best bid and offer price and the national best bid and offer price. That data is given to securities information processors which sell the information to companies such as Thomson Reuters and Bloomberg.
Opposing the exchanges’ stance is a lobbying group calling itself the NetCoalition which consists of Bloomberg, twenty Internet companies including Google and Yahoo, as well as the influential Securities Industry and Financial Markets Association. SIFMA represents about 600 brokerage firms.
"Nasdaq and NYSE Arca need to prove they are charging fair and reasonable fees," says Markham Erickson, a partner with the Washington DC law firm of Holch & Erickson which represents the NetCoalition. “To do so, they have to clearly explain how they calculate their costs for producing and distributing the data so that their profit margin can be understood -- and accepted by the securities industry and ultimately the Securities and Exchange Commission.”
Here’s where the Dodd-Frank bill comes in. In its application to the SEC in September, Nasdaq says it can charge what it considers market-based fees because the Dodd-Frank Act has created a "presumption that exchange fees, including market data fees, may take effect immediately, without prior Commission approval.” That means the SEC could only reject the fees if it has concerns that they may not be "consistent with the Act,” according to Nasdaq.
What exactly is a presumption?
The legislation never explicitly discusses market data fees so Nasdaq could be taking a big risk in its interpretation.
Section 916 of the measure called “Streamlining of Filing Procedures for Self-Regulatory Organizations” would apply to filings of rule changes by exchanges, as self-regulatory organizations, to the SEC.
The legislation amends Section 19b3 of the Securities and Exchange Act of 2934 to say that the SEC can temporarily suspend any change in rules if such action is necessary or appropriate in the public interest, for the protection of investors.
And what does Nasdaq now want to charge? $70 a month for what it calls its TotalView data. This is $70 a month for each device used by a professional subscriber or $14 a month for TotalView data for each non-professional subscriber.
A broker-dealer can also pay a maximum enterprisewide licensing fee of $25,000 per month for non-professional subscribers or $100,000 a month for both professional and non-professional subscribers. Those enterprisewide fees for both TotalView and OpenView Data allow the broker-dealer to redistribute data to external users with whom the firm has a brokerage relationship.
Nasdaq's TotalView -- a proprietary product -- provides what Nasdaq defines as non-core data --the full depth of book data for Nasdaq's Market Center Execution System; TotalView data is separate from Nasdaq's core or consolidated data. "Nasdaq continues to seek broader distribution of non-core data and to reduce the cost of providing non-core data to larger numbers of users," said Nasdaq in its application to the SEC.
While the NYSE Arca has not commented on the Dodd-Frank Act, it does have a big stake in how the SEC interprets the legislation. The NYSE Arca's application in 2006 to charge member firms to access ArcaBook was quickly approved by the SEC on the grounds that NYSE Arca proved it was subject to "at least two broad types of significant competitive forces." Those two forces were its need to attract order flow from market participants and the ability of market participants to choose other market data providers.
But in August 2010, a Washington, D.C., District Court of Appeals overturned the SEC's decision. In siding with a petition made by NetCoalition in February, the court decided that the SEC made a mistake when it approved NYSE Arca's application because the SEC didn’t prove there is a competitive marketplace for market data fees.
While the court didn’t explicitly order the SEC to ask NYSE Arca for its cost analysis, it left open the possibility it would have to do so. “Although we uphold the SEC's market-based approach against the petitioner's cost-based challenges, we do not mean to say that a cost analysis is irrelevant," said the court. "Without additional evidence of trader behavior, the SEC has not adequately supported its determination that the alternatives it identifies in fact constrain NYSE Arca's depth of book fees."
If the SEC has to ask NYSE Arca to price based on costs, then it will then have to ask Nasdaq to do the same. However, if the SEC interprets the Dodd-Frank Act the same way Nasdaq does, it won't. That is because, if one believes Nasdaq, the Dodd-Frank Act has effectively invalidated the District of Columbia court decision.
Surprisingly, Nasdaq didn’t ask the DC court to overturn its decision based on the Dodd-Frank Act. Such a request would have made more sense than simply taking its chances now with the SEC. NYSE Arca has asked the DC court to overturn its withdrawal of the SEC’s fee approval.
What’s so hard about calculating the costs of producing market data? In its application to the SEC in September, Nasdaq says that it’s impossible to calculate the costs of market data fees in isolation from the cost of all of the inputs supporting the creation of market data because doing so will underestimate the cost of the data."Rather, all of the exchange's costs are incurred for the unified purpose of attracting order flow, executing and/or routing orders, and generating and selling data about market activity,” says Nasdaq. “The total return that an exchange earns reflects the revenues it receives from the joint products and the total costs of the joint products.”
Net Coalition says it can’t be that hard to ask either the NYSE Arca or Nasdaq to explain their costs. Every company in America can come up with the cost of producing a product under generally accepted accounting principles
Okay, so what should the methodology be? When pressed by Securities Technology Monitor to come up with a formula, Erickson says that it isn't up to the NetCoalition to create it.
Here is Erikson’s formula: "The exchanges should not include other costs such as the costs of developing, maintaining or operating systems used for purposes other than the collection and distribution of the market data in question.”
In an age where regulators are demanding transparency, the exchanges are certainly not making themselves look transparent by refusing to cough up the costs of producing the market data. They are fueling industry speculation they don’t want anyone to know just how much profit they are making.
There has got to be someone willing to figure out just what accounting methodology they could use. It shouldn't have taken four years for the SEC and securities industry to figure out what NYSE Arca should charge. But neither should NYSE Arca or Nasdaq be given a free ride.
This article originally appeared on Securities Technology Monitor.
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