Protocol | 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."

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Photo: Caspar Camille Rubin/Unsplash

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