By Lou Pastina and Nancy Reich, Global Markets Advisory Group

Over the last thirty years there has been a power struggle among Exchanges and between exchanges and their members. At one time those members were owners of the Exchanges, when the markets were mutualized facilities acting on behalf of their members. In those days the concept was to pool resources to build infrastructure and reduce costs. That strategy worked for a long a time, until Exchanges were forced by regulators to modernize their markets in a bid to enhance transparency and competition. Exchanges started to really develop their technology capacity, replacing jobs once done by members, and more importantly raising their fees to pay for the ever-increasing costs of technology.

The fee increases didn’t sit well with the membership, and the mutualization benefits of the past dwindled as the need for other synergies emerged, with the development of different business strategies. What began as a limited third market with a few fringe broker-dealer players blossomed into a full upstairs, non-exchange-based opportunity to increase profits and reduce costs, enhanced by their freedom from many of the restrictions to which exchanges were subject. Antagonism followed quickly and Exchanges became fully independent, less quasi-governmental utilities with murky boundary lines as to what separated them from everyday companies.

The former members, now customers, were free to openly compete with Exchanges and they did so with the financial might that Exchanges could only hope to compete with. While Exchanges still are symbols of our country’s economy, as they are in countries all around the world, only about 60 % of the overall daily volume is actually executed on the dozen or so equity Exchanges in the United States these days. The rest is executed in upstairs environments that include a plethora of systems including Alternative Trading Systems, Trading Desks, and quasi-exchange facilities. These systems offer lower cost alternatives to Exchanges and the opportunity to buy and sell order flow that increases profit opportunities for the firms.

Exchanges make money in only a few ways: they charge transactions fees in a myriad of fee structures that include paying for order flow; they charge for the results of that order flow in the form of market data, that is quotes and sales; and they charge corporate customers for the privilege of being available to trade on their market in the form of listings fees. If you are a futures exchange there are no listings fees, but futures exchanges make money by also clearing transactions.

As public companies, Exchanges are duty bound to do the best they can for their shareholders. Their customers, the one-time members, come second in that equation and they feel somewhat slighted by their former operators. So recently their disputes have boiled over into the courtroom, where the two sides have been before to resolve their differences. As in the past, the Securities and Exchange Commission, which is charged with regulating both broker-dealer firms and exchanges, has pushed the exchanges to reform their practices and be more “customer friendly,” if you will. The first court case was in regard to the ownership rights of market data and the ability to charge fees for the data, pitting the industry at large against the Exchanges. This was a battle that had been fought and decided many times before, even in court, with Exchanges usually winning. The most recent battle ended with the Exchanges once again winning. Which means that the Exchanges own the data and can charge reasonably fees for it. This did not make the firms happy, who feel they are being overcharged for their own data, and it probably didn’t make the SEC happy either. But there it is, where it has always been!

The second case was brought by the Exchanges against the SEC for pursuing a pilot program targeting how Exchanges charge transaction fees. The pilot, overly complicated, full of technology and operational costs, fraught with risks, was determined to be beyond the SEC’s authority by the courts. Again, a victory for the Exchanges, probably much to the chagrin of both the SEC and the firms.

The recent pandemic and increased volatility has put a damper on the Initial Public Offering business and therefore Exchange listings fees, but in essence there are two parts to listings fees: the initial fee and then a continuing fee. The continuing fee is like an annuity and that has been unaffected by the quarantine. But Exchanges, in addition to their court victories, have had a windfall in terms of volume. Recent volume trends have seen a doubling and sometimes tripling of volume for weeks at a time for Exchanges, and with reduced operating costs due to the pandemic, all that is probably going straight to the bottom line. And this probably exacerbates the antagonism between the three main protagonists — broker-dealers and other customers, the exchanges, and the SEC.

Now, a new player has entered the fray. On June 22, 2020, the SEC and the Antitrust Division of the Department of Justice (DOJ) signed an interagency “memorandum of understanding (MOU) to “foster competition and communication between the agencies” in an effort to enhance competition in the securities industry. According to the DOJ, the MOU will result in “robust, comprehensive analyses” regarding competition…” which in turn could result in “healthier markets yielding enhanced consumer benefits.”

Clearly, it is too early to tell what impact this more formal collaboration between the two government agencies will have on market data ownership and fees, although, the Wall Street Journal has suggested that the MOU may lead to antitrust scrutiny of fees charged by exchanges for information, including market data. And while the previous court decisions provide strong legal precedent favoring the exchanges’ position, the past has shown that when the SEC focuses on competition, it is often to the detriment of the exchanges. Another unknown is what effect the emergence of two new exchanges — the Long-Term Stock Exchange and the Members Stock Exchange will have on this issue, given the increased competition in the lit markets. The only group that seems without a voice in these contests are the actual investors. Let’s hope they get it right and keep the markets running, fairly, cost effectively and open for all.

GMAG is an advisory firm focused on the intersection of finance, compliance and technology. Lou Pastina is a Managing Member and Nancy Reich is a Senior Consultant to GMAG.