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Stock Exchanges Are Eating Your Returns

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Over the past decade, the widespread availability of information and new technologies has helped establish the most level playing field in financial markets we’ve ever seen.

But there’s an exception to this positive trend: Exchanges are quietly, yet dramatically, increasing the fees they charge for market data and access to compensate for their own dramatic declines in market share as the revenues of brokers, specialists, market makers and other users of stock-exchange services have toppled. The result is that the exchanges are making it more expensive to trade, and that’s harming investors.

The numbers tell the story: Total quarterly revenue of the major U.S. equity exchange groups (BATS Global Markets; Intercontinental Exchange, which owns the New York Stock Exchange and other futures and options markets; and Nasdaq) grew almost 16 percent from the first quarter of 2010 through the third quarter of 2015, to $1.8 billion from $1.5 billion. Diving deeper, the exchanges’ technology and data revenue increased 62 percent.

This occurred while their customers’ trading revenues declined sharply. For so-called liquidity providers, which include market makers and dealers, the fall was steep: 75 percent. The commissions paid by large money managers for trading stocks on their behalf dropped 20 percent, and the largest banks and brokers’ equity trading revenues shrank by 29 percent.

Unfortunately, market participants have no choice but to pay the exchanges’ ever-increasing fees for data and access, without which traders wouldn’t have the most up-to-date information, and brokers would run afoul of the Securities and Exchange Commission’s best-execution rules. With operating margins more than double many of their broker and market-maker clients’, exchanges seem to be taking advantage of this protected positioning. (Disclosure: Many of Tabb Group’s clients purchase market data.)

To understand why investors continue to get hit with higher fees, it’s important to consider exactly how exchanges make their money. Outside of listings, stock exchanges basically have two main revenue sources: the fees they charge for matching buyers and sellers, and the fees they charge for data and exchange access.

Historically, revenue from trading was considerable and reliable. In recent years, however, the emergence of new electronic trading venues has created a highly competitive marketplace, giving investors more choice, tighter bid-ask spreads, more attractive pricing and better execution.

The effect has been dramatic. A decade ago, the U.S.’s largest exchange, the NYSE, handled about 80 percent of the trades for its own listed companies. Today, that share has plummeted to about 20 percent. Nasdaq, the largest individual exchange today, has a market share across all equities of 15 percent, while the largest equity exchange group, Intercontinental, has only a 24 percent share.

Faced with declining volume and revenue, exchanges have sought to replace this lost business. This is where that second source of revenue — the fees they charge for market data and access — comes into play.

Exchanges have increasingly exerted their control over market data, squeezing market participants by demanding progressively higher fees. In addition, exchanges are effectively providing preferential access to those who agree to pay for more expensive or faster customized products.

This strategy harms investors and the market as a whole. Increasing data and access fees will force intermediaries (market makers and brokers) to recoup their costs by widening quotes or increasing commissions. Higher fees will also force out smaller players, making it harder to find liquidity and raising trading costs for everyone.

Why does this data oligopoly exist? It is a remnant of outdated government regulation. Exchanges were once considered utilities performing a public good, existing as places for buyers to meet sellers. In their role as utilities, exchanges received government-granted control over the collection and sale of certain market data, including quotes, orders and executed trades. Even after the exchanges converted to for-profit enterprises in the early 2000s, their control over the sale of data remained untouched.

While beholden to rules requiring them to provide the best execution possible to buyers and sellers, brokers and market makers can allocate a portion of their limit orders to competing exchanges (hence the exchanges’ plummeting market shares). But to ensure market orders are routed to the exchange displaying the best price, brokers need to buy market data from all exchanges, regardless of increasingly lower trading volumes and increasingly higher data and access fees.

Market participants have been fighting this anticompetitive situation for years. The Securities Industry and Financial Markets Association and a coalition of Internet companies filed a lawsuit against the exchanges in 2006. In 2013, the U.S. Court of Appeals for the District of Columbia instructed the SEC to reexamine its approval of data fee increases and require the exchanges to justify the price hikes. Since then, the case has been awaiting review by the SEC’s own administrative court.

There are two paths forward. The first is to continue with the slow-moving litigation, which could still take years to resolve. The second, far preferable, path is for the SEC simply to recognize what has been true for years: Exchanges are now for-profit companies, and effective competition should occur across the enterprise.

If market-data pricing doesn’t become more competitive on its own, the SEC should use its authority to require the exchanges to compete. As long as regulators force market participants to buy data from the exchanges, they should make sure there is a process to price data more competitively — or at least, what customers perceive to be more equitable pricing.

As long as exchanges have, in effect, a market-data oligopoly, investors should expect data fees to increase. In the long run, though, cross-subsidies rarely work. Exchanges won’t be able to make up for lower trading revenue with higher data fees forever. Healthy competition and innovation will always figure out a way to disrupt excessive-return strategies. For investors, that future can’t come soon enough.


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