Thursday, October 18, 2018

Commission says NYSE and Nasdaq flunked burden of proof on non-core data fees, sharpens focus on access to market data

By Mark S. Nelson, J.D.

The Commission unanimously decided to set aside certain data fees charged by NYSE Arca, Inc. and Nasdaq Stock Market LLC to market participants because the exchanges failed to demonstrate that the fees were fair, reasonable, and not unreasonably discriminatory, as required by the Exchange Act. The Commission also remanded 400 pending fee challenges to various exchanges but without setting aside those fees or otherwise opining on their propriety. The Securities Industry and Financial Markets Association (SIFMA) had challenged the propriety of NYSE Arca’s and Nasdaq’s depth-of-book access fees. The Commission’s opinion puts a spotlight on the specific fees charged by NYSE Arca and Nasdaq while also highlighting larger issues about unequal access to critical market data (In the Matter of the Application of Securities Industry and Financial Markets Association For Review of Action taken by NYSE Arca, Inc., and Nasdaq Stock Market LLC, Release No. 34-84432, October 16, 2018).

The market shifts: decimalization and high-speed feeds. The decade-long combination of litigation and administrative proceedings over NYSE Arca and Nasdaq’s depth-of-book access fees has its roots in the 1975 legislative mandate that the Commission create a national market system. During the intervening years, securities markets evolved dramatically and the more recent combination of decimalization and high-speed data access has facilitated the development of a lucrative business for market information. A further complication, however, arises from the existence of a two-speed market data system—a much slower core data set distributed via securities information processors (fees set based at least partly on cost), and faster, non-core feeds (which, among other things, include data on limit orders) that are sold directly by exchanges to market participants.

A 2008 Commission order emphasized the need for there to be significant competitive market forces regarding depth-of-book fees. In that order, the Commission found such market forces would prevent NYSE Arca from charging outsized data access fees. An appeal by SIFMA to the D.C. Circuit Court resulted in the NetCoalition I decision that upheld the Commission’s market-based approach (as opposed to a cost-based approach) for non-core data fees as permissible under Chevron deference while also finding the Commission did not vary from prior SEC practice. But the court found the administrative record did not support the Commission’s finding that NYSE Arca was subject to competitive forces that would curb its pricing power. A subsequent change in the law brought about by the Dodd-Frank Act permitted exchanges to file automatically effective rule changes regarding certain data access fees. As a result, NYSE Arca promulgated the same fee rule in 2010 and an appeal by SIFMA once again to the D.C. Circuit resulted in the NetCoalition II decision in which the court held that the Dodd-Frank Act deprived it of jurisdiction over the appeal. SIFMA then renewed its administrative challenges to both the NYSE Arca and Nasdaq fees and the matters were consolidated and assigned to an administrative law judge (ALJ) who, having previously found SIFMA had associational standing, ultimately decided in favor of the exchanges on the propriety of their data fees. The Commission explained that the assignment to an ALJ was discretionary and had been done for the purpose of expanding the record beyond that developed before the exchange but did not otherwise presage a change in how the Commission expects exchanges to handle similar proceedings.

Exchanges failed to meet burden of proof. The Commission’s opinion focused solely on non-core data fees charged by NYSE Arca and Nasdaq. NYSE Arca charged a $750 per month access fee and additional device fees based on whether the subscriber was a professional ($30/month) or non-professional ($10/month), with a cap for broker-dealers regarding non-professionals at $20,000/month. Nasdaq’s Level 2 Fee applied to a subset of its Total View data, which tracks Nasdaq-listed securities, and would have extended Total View fees to its Level 2 data feed.

The D.C. Circuit in NetCoalition I, which at times reads more like an antitrust case than a securities regulation case, explained why depth-of-book data, like that offered by NYSE Arca and Nasdaq, is so important to market participants: “In this way, depth-of-book data allows a trader to gain background information about the ‘liquidity’ of a security on a particular exchange, i.e., the degree to which his total sale or purchase price will differ from what he would receive if the entire trade were made at the prevailing best prices.”

According to the Commission, it must judge NYSE Arca’s and Nasdaq’s depth-of-book fees based on the standards contained in Exchange Act Section 19(f) which, among other things, requires that an exchange’s fees be consistent with the Exchange Act. An exchange, the Commission added, has the burden of showing this by a preponderance of the evidence. The Commission also explained that, drawing from NetCoalition I, elasticity of demand (how quickly customers abandon a product whose price has risen or adopt a product whose price has dropped) is key to evaluating competitive market forces.

Overall, the Commission rejected the exchanges’ argument that competition exists for depth-of-book data because customers can send order flow elsewhere or substitute products. As a result, the exchanges could not meet their burden of showing that their fees were fair and reasonable. The Commission had more to say about why that was the case, but it declined to mull whether the exchanges’ fees were not unreasonably discriminatory because that analysis was unnecessary if the exchanges failed to show their fees were fair and reasonable. Moreover, the Commission sought to explain what its opinion did not decide: “We do not, by our findings here, conclude that the fees are not fair and reasonable. Rather, the factual record and the theories based on that record put forward by the exchanges are insufficient to support a finding that the fees at issue meet the statutory test.”

With respect to order flow, the Commission, much as the D.C. Circuit had in NetCoalition I, noted that competitive pricing would not necessarily exist where a small number of firms account for a large portion of order flow but those same firms rely on depth-of-book data. The Commission also observed that the exchanges’ statistical analyses fell short, including in one instance by not properly comparing data before and after BATS became a national securities exchange. The Commission also, among other things, doubted the exchanges’ citation of a single order flow diversion and “unrealized threats” to do the same showed that the exchanges’ pricing would be curbed by market forces. Moreover, the Commission concluded that the record did not show that platform competition would limit depth-of-book prices; NYSE Arca had argued that other platforms could compete with its product “on other dimensions” such as trade execution.

As for the presence of alternative products, the Commission was similarly unpersuaded. Specifically, the Commission rejected as unsupported by the evidence NYSE Arca’s claim that it has little market power because its prices remain inelastic such that it can raise prices until prices eventually become elastic. The Commission also found that Nasdaq failed to show that its pricing was elastic.

Lastly, the Commission found little support for the exchange’s asserted substantial, non-competitive bases for upholding their fees, such as general benefits to the marketplace by providing depth-of-book data. Likewise, the Commission noted that the exchanges never presented evidence of cost data in support of their fees. The D.C. Circuit in NetCoalition I observed that “…we do not mean to say that a cost analysis is irrelevant.” The court went on to explain: “… the costs of collecting and distributing market data can indicate whether an exchange is taking ‘excessive profits’ or subsidizing its service with another source of revenue, as the SEC has recognized” (citing an SEC concept release).

Peirce and Roisman concurrence. Commissioners Hester Peirce and Elad Roisman concurred in the Commission’s opinion via a separate joint statement. Specifically, Peirce and Roisman question the continued viability of the order protection rule contained in Rule 611 of Regulation NMS, something they said the Commission’s opinion addressed only tangentially. “[W]e call upon the Commission to do a retrospective review of the Order Protection Rule and other interrelated aspects of equity market structure: Why do we still have the Order Protection Rule? Who are we protecting? From what? And would other rules or market dynamics serve to protect these interests in a more efficient, and less costly, manner?”

The Commission noted in footnote 164 that Rule 611 may hinder firms’ ability to divert order flow from high-priced venues. The Commission was more specific in its comment in footnote 183: “[W]e think NYSE Arca overstates the case by claiming that traders can ‘flee’ an exchange. Firms must be cognizant of the Order Protection Rule and best execution obligations. To the extent firms have the ability to move order flow in response to data pricing decisions, they would have to do so consistent with these and other regulatory requirements.”

Peirce and Roisman also noted the lack of guidance from the Commission regarding how exchanges should handle the many fee challenges remanded to them via a separate Commission order. The commissioners suggested three options: (1) conduct a market segment analysis based on customer type; (2) perform a full platform analysis to understand how total cost, not discrete fees, impact pricing; or (3) engage in cost-based analysis, although Peirce and Roisman view this last option as undesirable because of the potential for the Commission to become a rate-setter.

Narrow scope, but indicative of wider problem. Although the Commission set aside NYSE’s and Nasdaq’s data fees, the commissioners suggested that the decision was somewhat limited in scope. In the penultimate paragraph at the end of the opinion, the Commission said: “[W]e emphasize that in finding that the exchanges have not met their burden of proof with respect to the competitiveness of the market, we are not finding that the market is not competitive. Our findings are limited to the record developed by the parties, and the arguments based on that record. We express no views on what conclusions might be reached on a different record.” The Commission also emphasized that its opinion dealt only with the specific NYSE Arca and Nasdaq fees challenged and did not address any subsequently revised fees, which would remain in effect subject to any challenges.

SEC Chairman Jay Clayton also issued a public statement on the Commission’s opinion in which he sought to put the decision and the related remand order into a larger context: “The matters addressed in today's orders have been before the Commission for a substantial period of time. I believe that as we move forward, today's actions will enable the Commission and market participants to more efficiently and effectively ensure that market data fees are set, reviewed and regulated in the best interest of our markets and our Main Street investors. More generally, I believe these actions, taken together with other initiatives of the Commission and our dedicated staff, will improve our regulation of market structure as it exists today and will inevitably continue to evolve.”

The SEC has in recent years heard many complaints about fees for access to market data and will soon host a roundtable on the topic. Technological evolution and the advent of high speed trading make access to current market data a lucrative business and essential tool for many investors.

SIFMA issued a brief statement praising the Commission’s order. “This pragmatic ruling by the SEC indicates increasing recognition by policymakers that the fee structure for proprietary market data products is broken,” said Melissa MacGregor, SIFMA managing director and associate general counsel. “Today’s decision should prompt further examination of policy reforms to ensure the efficiency of public market data feeds and fairness of fees.”

NYSE responded to the Commission’s decision regarding NYSE Arca’s fees by noting how little effect it was likely to have on the exchange’s current products and fees. NYSE ARCA also suggested it would challenge the Commission’s opinion. “This decision represents a troubling shift by the SEC from its core mission of ensuring the long-term health of our financial markets to an agenda of regulatory overreach, prioritizing the interests of powerful Wall Street interests over those of retail investors and listed companies. We believe the Commission’s decision will not withstand our challenge.”

The Commission’s order also comes soon after developments in a matter in which BOX Exchange LLC asked the Commission to review a decision by the Division of Trading and Markets to temporarily suspend and institute proceedings regarding BOX’s proposed rule change that would impose fees on those who physically connect to the exchange while also reclassifying fees charged to high speed data feed users. The BOX order is one of the few times the SEC has taken such action, and also suggests a heightened interest by the agency in reviewing market data fees.

The release is No. 34- 84432.