April 2006

Data Pricing and Dissemination in a Competitive Securities Market

Few investors know that when they ask their broker for a current price of a New York Stock Exchange (NYSE) or NASDAQ stock, the broker is paying for this data and that the revenue from the sale of market data is a major source of revenue for all the exchanges. The price for market data is set by a consortium of all the exchanges trading the same securities and is thus a price set without competition. The consortium then disseminates a data stream that contains consolidated data from all the exchanges. Over the thirty years since this structure was established by the Securities and Exchange Commission (SEC), many have wondered whether a price set in this way reflects the value of the data, whether data from all the exchanges are necessary for investors, and even whether the data properly belong to the exchanges that profit from their sale. Now that the NYSE and NASDAQ are both private, profit-making companies, these questions are coming to the fore with greater urgency. One reason the exchanges have privatized is to meet the competition from new electronic trading venues, and some observers have suggested that this new competitive environment provides a basis for competition in pricing market data. At an April 6 AEI panel, a group of experts discussed how the major exchanges are approaching this issue and what alternatives there may be for modifying the current system.

Peter J. Wallison
AEI

Following the passage of the 1975 amendments to the Securities Exchange Act of 1934, the SEC issued regulations requiring that market data be collected, consolidated, and disseminated at a set price through a consortium of exchanges. When the SEC promulgated these requirements, exchanges were structured as mutual institutions, the NYSE was the dominant market for most major securities, and the possibility existed that investors might receive incomplete or misleading data. Thus, at the time, the regulation might have been justified. Today, however, exchanges are private, profit-making corporations, competing with one another for the trading interests of investors.
Because the consortiums are the sole source of market data, there is no way to know if the price for data reflects its true market value, or is a monopoly, profit-maximizing price. However, given the changes that have taken place in the securities market since the 1975 amendments, a competitive market in market data could exist. If vendors were permitted to compete freely with one another, they would charge a market-determined price for the data and disseminate it in whatever form they determine is most desirable for buyers. Although it is impossible to predict the exact consequences of deregulation, experience has shown that competition drives down costs and promotes innovation. The aim of this conference is to understand the perspectives of the major parties involved in the debate over the sale of market data. 

Jeffrey T. Brown
Charles Schwab Corporation

Market data is the basis upon which all investment decisions are made, and hence broad access to data is of utmost importance. When investors have more information at their disposal, they can make better investing decisions. However, higher prices restrict investors’ access to the necessary data. Since 1999, when Schwab petitioned the SEC to review the current fee structure for market data and propose new rules, the SEC has done little more than issue concept releases and hold hearings. The commission has yet to take any concrete regulatory action to respond to dramatic changes in the securities market. Exchanges are no longer structured as mutual, club-like institutions. They are now for-profit, publicly held corporations with profits based in part on market data revenue streams. Further, electronic communication networks--until they are swallowed up by exchanges--place their market data on the Internet for free.

The problem with the current structure of market data pricing is that the exchanges operate as a cartel to fix the prices. The exchanges limit access to critical data--the full book--through high fees, which creates a two-tiered market. One level consists of professional investors who have the information, and the second consists of the retail investors that do not. Further, the exchanges fail to justify their fee levels, provide no reference to the cost of compiling data, and have no articulated standards of reasonableness and fairness. They restrict and control distribution of data through contracts of adhesion, and they use fee revenue to fund competitive activity.

There should be a new regulatory approach to market data pricing and dissemination. Independent accounting should see that fees are based on the actual cost of consolidation, there should be public participation in the governance of the cartels, rules should be unified to create a uniform fee structure and minimize administrative burdens, and additional information should be included in the consolidated quote stream for the benefit of retail investors.

In response to a question by Mr. Wallison on the intrinsic problems of price-setting, Mr. Brown said that it is unlikely the SEC will open the market to competition. Also, Regulation NMS, which the SEC issued in 2005, extended the trade-through rule to NASDAQ and all electronic exchanges, thereby giving brokers little ability to purchase anything other than through the use of consolidated data. Because brokers must ensure that they are not trading-through, they must see all the data to make sure they are purchasing securities at the lowest price. Thus, Regulation NMS stands in the way of substantial reform in the structure for market data.

Jamie Selway
White Cap Trading

The 1975 amendments to the Securities Exchange Act of 1934 created the national market system (NMS), which, among other things, requires the collection and dissemination of market data. Essentially, the NMS plans created three linkages. First, an information linkage was provided by the Consolidated Tape Association Consolidated Quotation Plan (CTA/CQ). The CTA/CQ Plan governs the collection, processing, and distribution of quotation and transaction information for exchange-listed securities. Second, there was a physical linkage provided by the Intermarket Trading System (ITS), an electronic communications network that links nine U.S. markets--the New York, American, Boston, Chicago, National, Pacific, and Philadelphia Stock Exchanges; the Chicago Board Options Exchange; and the National Association of Securities Dealers (NASD). Third, there was a regulatory linkage, formalized by SEC rulemaking but with roots in the common law agency concept, which stipulated that brokers had an obligation to provide the best price when executing investor orders. In terms of the information linkage, prices for market data were set by the CTA/CQ Plan and are subject to SEC oversight.

Since the late 1990s, developments in the securities market have demonstrated that data under the current NMS structure is too expensive. In the late 1990s, regional exchanges began to rebate tape revenue associated with trades as part of a retail payment-for-order flow plan. During 2000 and 2001, electronic communications networks (ECNs) began to rebate tape revenue earned on trades, especially on trades of exchange traded funds. In fact, when Island ECN and the Cincinnati Stock Exchange proposed a rebate of 90 percent of tape revenue in 2002, the SEC intervened and imposed a 50 percent rebate cap based on the theory that market data revenue is necessary to fund the exchanges’ regulatory programs. As rebates grew, trading became cheaper, which led to increased volume. By way of example, the Tape B (Amex-listed securities) per-trade market data rate dropped from $12 in the 1990s to roughly $0.60 today. In order to maximize rebated revenues, some market participants resorted to “tape shredding,” a practice in which a single order is sliced into multiple smaller orders, for the purpose of creating additional trade executions. Along with the rebates, certain exchanges started offering full book data--which is richer than NMS data--free of charge over the Internet.

There are different possible futures for the national market system. One would entail revising Regulation NMS, under which the size of the total market data revenue would not change, but the sharing formula would be revised, and fees would be calculated based on a new, complex two-step formula. Data on stocks that trade at a heavy volume would be worth less than data for stocks that sell at a lesser volume. Also, prices would be weighted 50 percent for trading and 50 percent for quoting. Tape shredding would be banned. The data would still be valued by arbitrary formulas and not the marketplace, the SEC would retain its role in valuation, and since the exchanges still compete, there would continue to be an incentive for rebates.

Another future would entail deregulation, in which exchanges would vend data products competitively based on value and price. The likely results would be that the price of regulated data would be compressed, the exchanges would have an incentive to innovate via proprietary products, dead-weight accounting costs would be eliminated, and there would be improved transparency. However, deregulation faces challenges. The SEC is concerned with protecting investors, and the commission fears that if prices were left to the market, they would rise.

Mark Schaedel
NYSE

The consolidation of data has outlived much of its usefulness. In the past, it was helpful in connecting people with all prices, and ultimately, the best prices. Today, however, consolidation serves few useful functions. Fortunately, Regulation NMS permits exchanges to market their own stream of proprietary data and compete with the consolidated data. Indeed, the NYSE prefers to market its products competitively, rather than have to work with its competitors to agree on the price for data. Investors should not be forced to pay for data they do not want, and thus the NYSE is developing its own "Level 1" product that will essentially provide the NYSE Group’s Consolidated Tape input of quotes and last sale prices directly to investors at a lower cost basis and lower latency than available via the consolidator.

NYSE will also offer, through its NYSE InfoTools suite, a series of real-time and historical products that essentially decompose the information provided through its Level 1 product into more granular, underlying components--often useful in quantitative analytics. The NYSE also offers the NYSE OpenBook, which is in real-time, and ArcaBook. Both of these products go beyond the consolidated data and provide full depth of book information. Rounding out their product portfolio, the NYSE offers NYSE Broker Volume, which ranks the market participants in terms of their respective trading activity.

Mr. Wallison asked if the NYSE believes that data revenue is necessary to fund the regulatory functions of the exchange. Mr. Schaedel responded that data revenue is an important component of the business, and is perhaps the most widely distributed source of funding. Also, market data takes the pressure off having to rely on other, more concentrated, sources of revenue which have the potential of introducing friction to the Exchange’s business activities.

Adena Friedman
NASDAQ

NASDAQ has encouraged the SEC to limit the scope of the current government-sponsored cartel on data pricing to just the national best bid/offer (NBBO) data. NBBO data should be treated as a public good because investors must know the best price for securities before they decide to trade. Thus, government regulation should structure the consolidation, calculation, and dissemination of this data, although it should be offered at a lower price than it is now. Currently, professional investors pay about $20 per month for this data, when the price should be closer to between $5 and $7. The pricing and dissemination of all other proprietary data, however, should be deregulated and left subject to market forces and competition. NASDAQ maintains that if it could offer its trade data without having to negotiate the price and dissemination with six other exchanges, it could provide the information in a faster, cheaper, and more flexible way.

AEI staff assistant Dan Geary prepared this summary.