Fintech

It's not just Robinhood. Money-hungry stock exchanges are under scrutiny too.

Some critics have compared the way exchanges attract orders from customers to the payment for order flow system that has enriched retail brokers.

New York Stock Exchange

The New York Stock Exchange is now owned by the Intercontinental Exchange.

Photo: Aditya Vyas/Unsplash

As questions pile up about how powerful and little-known Wall Street entities rake in profits from stock trading, the exchanges that handle vast portions of everyday trading are being scrutinized for how they make money, too.

One mechanism in particular — exchange rebates, or payments from the exchanges for getting certain trades routed to them — has raised concerns with regulators and members of Congress.

Exchange rebates have existed since the 1990s, notably gaining traction in 1997 when Island ECN, an electronic trading service formed by day-trading firm Datek Securities, started offering rebates to draw more orders and compete with Nasdaq.

Critics say that exchange rebates present a conflict of interest by causing brokers to send trades to exchanges that offer rebates, even if that results in worse pricing. High-frequency traders have learned to take advantage of these rebates, engaging in multiple forms of arbitrage. And the rebates have led to market concentration and a reduction in competition, which hurts pricing for all investors, according to some analyses.

The debate about exchanges has broadened into other ways that they make money, including the sale of proprietary data.

Exchange rebates are part of a broader and complex system of trading, where retail orders get sent to wholesale market makers and large institutional orders typically get sent to exchanges. Robinhood, which went public Thursday, has drawn considerable attention to the system of payment for order flow that dominates retail trading. But even though exchange rebates typically involve large institutional trading, the system ends up affecting the prices retail investors pay for their shares, too.

Because rebates are a fraction of a cent per share and the data is complex to analyze, these charges have gotten perhaps less scrutiny than other parts of the market. Recent estimates are lacking, but one 2012 study estimated the costs at around $5 billion a year. The effects cascade through the market: Costs borne by a mutual fund or a pension fund end up getting paid by retirement savers.

There is regulatory interest in the rebates. The SEC recently tried to run a "transaction fee pilot" to evaluate changes to the practice, with support from a number of prominent asset managers, but the NYSE, Nasdaq and CBOE successfully sued to stop the pilot in 2020.

The issue may be revived under a new administration, however. SEC Chair Gary Gensler recently said that the SEC is looking at payment for order flow and exchange rebates. "I've asked staff to take a closer look at this in the context of overall market structure," he told members of Congress during a May hearing. FINRA also recently sent a notice to firms reminding them of the SEC's best-execution guidance, including that "a broker-dealer must not allow a payment or an inducement for order flow to interfere with its efforts to obtain best execution."

How exchange rebates work

Most exchanges operate on the "maker-taker" model, where exchanges pay investors for providing liquidity to the market by filling orders at, for example, 30 cents per 100 shares, and they charge investors who send orders to the market and take liquidity at a smaller amount, like 20 cents per 100 shares.

The big exchanges say rebates provide better liquidity and pricing for the entire market and that regulation ensures investors get the best prices. Nasdaq's chief economist, Phil Mackintosh, has said that both makers and takers benefit from the model, and that price improvement for trades is "often larger than the take fees charged." In other words, the cost of the rebates is more than covered by better prices that investors get on these trades.

Jeffrey Sprecher, CEO of Intercontinental Exchange (which owns the NYSE), once said that regulators should look at exchange rebates. But more recently, the company has pushed to keep them in place. Rebates are incentives for investors to set prices in the open market, which offsets trading that has moved to dark pools, NYSE President Stacey Cunningham wrote in an opinion piece explaining the exchange's decision to sue the SEC over the transaction fee pilot.

One way that rebates can affect investors: Brokers can send orders to exchanges to wait, or rest on the exchanges, in order to get rebates, which is where a conflict can arise, critics say. The brokers do this even though the orders can sit at the end of a queue of orders, which means that they can get worse pricing. In other words, brokers are giving up speed of execution in order to get the exchange rebates.

On exchanges, high-frequency traders, armed with better data and technology, can execute trades faster than these slower orders, said Daniel Aisen, CEO at Proof Trading, a startup competitor to the large exchanges. In a common "latency arbitrage" strategy, if an HFT knows that the market is moving on a particular stock, it can buy at a fractionally better price, a fraction of a second faster, and resell it to fill the waiting order.

The pricing of rebates varies, typically with better pricing for clients trading a larger percentage of total daily market volume. This benefits larger clients and makes it harder for smaller firms to compete, which hurts competition, Aisen said. Exchanges have argued that they do offer some pricing mechanisms to help smaller traders.

Feasting on data

At the same time, over the last 10 to 15 years, proprietary data and technology services have become a bigger focus for exchanges.

The NYSE made 13% of its revenue from tech services and market data in 2009. In 2020, Intercontinental Exchange, which bought the NYSE in 2012, saw data and connectivity services make up 22% of revenue across its exchanges.

Nasdaq in its quarter ending in June made $312 million in net revenue from market services which include trading, while it made $263 million from investment intelligence, which includes market data, and $117 million from market technology. (It also made $154 million from corporate platforms, which include listing services.)

Critics of the big exchanges say they charge high fees — that keep rising — for these proprietary data feeds that only the largest firms can pay for. One study by the Securities Industry and Financial Markets Association found that NYSE fees for proprietary data increased 1,100% from 2010 to 2018.

Because the proprietary data feeds are faster and provide more information than the public feed of trades, it has led to a two-tiered system, critics say. In response, the SEC has proposed making much more private data available on the public feed, but major exchanges in February sued to stop this change.

The competitive effect

These proprietary data feeds are anti-competitive because they are essentially necessary for many firms to operate, said Proof Trading's Aisen. Unless you are getting the fastest data and the best data, you can't compete with other traders. For example, a "latency arbitrage" strategy only works if a firm buys proprietary data feeds, Aisen said: The public data is too slow and not detailed enough.

"Exchanges have been squeezing brokers with ever-higher costs for data and technology, and the rebates they pay out provide relief only for a relative few that can qualify for high rebate tiers," said John Ramsay, IEX's chief market policy officer. "The effect is to increase costs of entry and constrict competition."

As data fees and other costs rise, concentration grows. The number of clients for each of the three largest exchanges has dropped 44% for the Nasdaq and 26% for NYSE since 2012. Meanwhile, the number of designated market makers for the NYSE has fallen from about 55 in 1987 to three today.

The intricacies of exchange rebates, payment for order flow, proprietary data feeds and other aspects of modern markets that are largely opaque to people outside the trading world add up to a system that favors "a short roster of very sophisticated practitioners," said Paul Rowady, director of research at Alphacution Research Conservatory.

Payment for order flow and exchange rebates are part of what he calls a "liquidity economics framework" that is increasingly having a "distortive impact," he added: "The question in front of key market stakeholders today is what to do about it."

Workplace

You need a healthy ‘debate culture’

From their first day, employees at Appian are encouraged to disagree with anyone at the company — including the CEO. Here’s how it works.

Appian co-founder and CEO Matt Calkins wants his employees to disagree with him.

Photo: Appian

Matt Calkins often hears that he’s polite, even deferential. But as CEO of Appian, he tells employees to challenge each other — especially their bosses — early and often.

“I love arguments. I love ideas clashing,” Calkins said. “I regard it as a personal compliment when someone respectfully dissents.”

Keep Reading Show less
Allison Levitsky
Allison Levitsky is a reporter at Protocol covering workplace issues in tech. She previously covered big tech companies and the tech workforce for the Silicon Valley Business Journal. Allison grew up in the Bay Area and graduated from UC Berkeley.

Some of the most astounding tech-enabled advances of the next decade, from cutting-edge medical research to urban traffic control and factory floor optimization, will be enabled by a device often smaller than a thumbnail: the memory chip.

While vast amounts of data are created, stored and processed every moment — by some estimates, 2.5 quintillion bytes daily — the insights in that code are unlocked by the memory chips that hold it and transfer it. “Memory will propel the next 10 years into the most transformative years in human history,” said Sanjay Mehrotra, president and CEO of Micron Technology.

Keep Reading Show less
James Daly
James Daly has a deep knowledge of creating brand voice identity, including understanding various audiences and targeting messaging accordingly. He enjoys commissioning, editing, writing, and business development, particularly in launching new ventures and building passionate audiences. Daly has led teams large and small to multiple awards and quantifiable success through a strategy built on teamwork, passion, fact-checking, intelligence, analytics, and audience growth while meeting budget goals and production deadlines in fast-paced environments. Daly is the Editorial Director of 2030 Media and a contributor at Wired.

Gopuff says it will make it through the fast-delivery slump

Maria Renz on her new role, the state of fast delivery and Gopuff’s goals for the coming year.

Gopuff has raised $4 billion at a $15 billion valuation.

Photo: Gopuff

The fast-delivery boom sent startups soaring during the pandemic, only for them to come crashing down in recent months. But Maria Renz said Gopuff is prepared to get through the slump.

“Gopuff is really well-positioned to weather through those challenges that we expect in the next year or so,” Renz told Protocol. “We're first party, we control elements of our mix, like price, very directly. And again, we have nine years of experience.”

Keep Reading Show less
Sarah Roach

Sarah (Sarahroach_) writes for Source Code at Protocol. She's a recent graduate of The George Washington University, where she studied journalism and criminal justice. She served for two years as editor-in-chief of GW's independent newspaper, The GW Hatchet. Sarah is based in New York, and can be reached at sroach@protocol.com

Enterprise

AT&T CTO: Challenges of the cloud transition are interpersonal

Jeremy Legg sat down with Protocol to discuss the race to 5G, the challenges of the cloud transition and nabbing tech talent.

AT&T CTO Jeremy Legg spoke with Protocol about the company's cloud transition and more.

Photo: AT&T

Jeremy Legg is two months into his role as CTO of AT&T, and he has been tasked with a big mandate: transforming the company into a software-driven business, with 5G and fiber as core growth areas.

This isn’t Legg’s first CTO gig, just his biggest one. He’s an entertainment biz guy who’s now at the center of the much bigger, albeit less glamorous, telecom business. Prior to joining AT&T in 2020, Legg was the CTO of WarnerMedia, where he was the technical architect behind HBO Max.

Keep Reading Show less
Michelle Ma

Michelle Ma (@himichellema) is a reporter at Protocol, where she writes about management, leadership and workplace issues in tech. Previously, she was a news editor of live journalism and special coverage for The Wall Street Journal. Prior to that, she worked as a staff writer at Wirecutter. She can be reached at mma@protocol.com.

Workplace

How Canva uses Canva

Design tips and tricks from the ultimate Canva pros: Canva employees themselves.

Employees use Canva to build the internal weekly “Canvazine,” product vision decks, team swag and more.

Illustration: Christopher T. Fong/Protocol

Ever wondered how the companies behind your favorite tech use their own products? We’ve told you how Spotify uses Spotify, How Slack uses Slack and how Meta uses its workplace tools. We talked to Canva employees about the creative ways they use the design tool.

The thing about Canva is that it's ridiculously easy to use. Anyone, regardless of skill level, can open up the app and produce a visually appealing presentation, infographic or video. The 10-year-old company has become synonymous with DIY design, serving as the preferred Instagram infographic app for the social justice “girlies.” Still, the app has plenty of overlooked features that Canvanauts (Canva’s word for its employees) use every day.

Keep Reading Show less
Lizzy Lawrence

Lizzy Lawrence ( @LizzyLaw_) is a reporter at Protocol, covering tools and productivity in the workplace. She's a recent graduate of the University of Michigan, where she studied sociology and international studies. She served as editor in chief of The Michigan Daily, her school's independent newspaper. She's based in D.C., and can be reached at llawrence@protocol.com.

Latest Stories
Bulletins