By Lene Powell, J.D.
In a hearing of the capital markets subcommittee of the House Financial Services Committee, lawmakers heard from securities exchanges, market makers, and brokerages in a broad exploration of equity market structure issues including data feeds and broker rebates, among other topics.
SIP vs. proprietary feeds. Many lawmakers sought input about market data and incentives—what market information is available, who pays for it, and whether current arrangements disadvantage any market participants. Jeff Brown, a senior vice president at Charles Schwab appearing on behalf of SIFMA, noted that the Securities Information Processor (SIP) feeds are slower than proprietary data feeds and contain only ephemeral top-of-book quotes. Brown pointed out that broker-dealers are required by rule to provide the raw material for the feeds to the exchanges, and then by rule must buy back the finished product—thus generating guaranteed profits for exchanges. That was a nice business to be in, he said.
Also, said Brown, the SIP has failed before and could fail again, but exchanges do not particularly have an incentive to improve it. “The fact is, exchanges and the members of the NMS Plan Governing Committee that oversees the SIP are never going to make the SIP so good that it would cannibalize the proprietary data feeds which they sell. There’s a conflict. Why would you ever do that?”
To ensure that market data is timely, comprehensive, nondiscriminatory, and accessible to all market participants at a reasonable cost, Brown believes the SEC should consider enhancing the SIP feeds with bid and offer quotes beyond the top of book data and provide that as the sole source of consolidated market data to meet regulatory obligations. Brown also urged the SEC to consider replacing the single-consolidator SIP model of market data dissemination with a competitive construct, such as a Competing Market Data Aggregators model.
Brad Katsuyama, CEO of the IEX Group, Inc. and Investors Exchange LLC, agreed that exchanges have conflicts of interest related to selling market data. According to Katsuyama, the proper role of an exchange is act as a neutral referee, providing the most accurate price to both sides of the trade, but exchanges fail in this role by selling a faster view of market data to high speed traders than the exchange itself relies on to price trades on its own market. The national stock exchanges have made a conscious decision to sell high-speed data and technology, instead of allowing third-party vendors to compete at selling these products. This conflicts with exchanges’ regulatory role and gives them monopoly power, said Katsuyama. He said that one broker recently stated their market data costs have increased 700 percent since 2008, which he finds especially striking given that technology costs have dropped in other industries.
Broker rebates. Katsuyama also criticized what he called a “harmful but easily addressed” conflict of interest: exchanges paying $2.5 billion dollars a year in rebates to brokers to send them orders. Exchanges reap profit by selling the orders back to the industry in the form of market data, he said, and it creates a conflict of interest for brokers because they keep the vast majority of rebates the exchanges pay them, even when routing client orders.
According to Katsuyama, two former SEC chief economists stated that “in other contexts, these payments would be recognized as illegal kickbacks.” He said that publicly available data shows that exchanges who pay the highest rebates per share for providing liquidity provide, on average, worse execution quality. Despite this, these exchanges have the longest lines to trade.
“Would a reasonable person ever wait on the longest line for a worse outcome? The answer is no, but in the equity markets that’s happening millions of times a day, every day, as brokers are paid to get in the longest lines despite what is in the best interest of their clients,” said Katsuyama. He thinks that some brokers manage this conflict well, but others do not—and the ones that do not, end up making more money.
Tom Farley, president of the New York Stock Exchange (NYSE) said he thinks that broker-dealers are conscientious actors who acknowledge an inherent conflict of interest regarding rebates. The question is how to set up the right structure to deal with that and minimize the conflict of interest. He believes the dealer community and asset management community should be involved in oversight of the SIP. A NYSE advisory committee has become more active over time on this issue, he said.
Chris Concannon, president and chief operating officer of the Chicago Board of Options Exchange (CBOE), also took issue with Katsuyama’s criticism of broker rebates, saying the notion of banning rebates showed a lack of understanding of how the market works. According to Concannon, the large majority of liquidity rebates go to proprietary market makers trying to form prices, not brokers. These market makers support small companies, small ETFs, and newly issued ETFs that demand that support.
Concannon noted that when brokers receive rebates, they’re still subject to best execution requirements. He said it’s somewhat insulting to suggest that some of the largest brokers in the country are not performing their best execution obligations because of a conflict of interest.