If you blinked on Friday, perhaps distracted by planning your long weekend, you missed an odd bit of news: the NYSE, NASDAQ and Cboe Global Markets are suing the US Securities & Exchange Commission. That the 3 largest US equity exchanges would sue their primary regulator is, for lack of a better word, weird.
At issue is something called the Transaction Fee Pilot, an SEC initiative that would experiment with how much exchanges can charge to execute a trade.Here’s how it will work:
- One test group of 730 names will see an exchange fee cap of $0.01/share.
- For a second group of 730 stocks, exchanges would not be able to pay rebates to clients (broker dealers) who provide liquidity.
- The pilot only applies to stocks that trade +30,000 shares/day and have a stock price over $2. See the SEC’s full description here: https://www.sec.gov/news/press-release/2018-298
We think that exchanges are suing to stop the pilot for 2 reasons:
- This is a major shift in US equity market structure, which often relies on maker-taker pricing to encourage liquidity to cluster in the numerous exchanges/trading pools where stocks trade. Maker-taker pays brokers to show sell orders (maker) and charges them to buy stock (taker).
Taking +700 names out of this system could lead to market volatility since it would reduce the number of trading venues that would be available to provide market-making services.
- It would reduce profitability at the 3 exchanges now suing the SEC by cutting the fees they can charge on the “taker” side of the equation. Critics of maker-taker say the system can influence where brokers send orders, maximizing their “maker” rebate rather than the client’s transaction price.
Our 2 cents on the topic: we suspect the exchanges also remember the SEC’s Tick Size Pilot, a 2 year experiment that ended in September 2018. In this experiment, the Commission bucketed less-liquid small cap stocks into several classifications, pushing some to $0.05 spreads while leaving others at $0.01 and mixing/matching if trades could occur inside the nickel spread as well.
The hope was that by mandating nickel spreads more liquidity would cluster at those price points and make illiquid small caps a little easier to trade. As a side (hoped for) benefit, greater market-making profits were supposed to encourage more stock research in small caps and a more IPO – friendly public equity market.
None of this really happened, and Barron’s even wrote a scathing review of the Tick Size Pilot, estimating that it cost (mostly retail investors) up to $900 million because of the artificially wider spreads: https://www.barrons.com/articles/sec-tick-size-pilot-program-1536961160
We were at a large agency broker dealer during the Tick Size Pilot, and we know one thing about such experiments: gearing up for these programs costs significant money and time. Everyone in the industry pretty much hates these experiments because they squeeze already thin industry profit margins.
We’ll close on the most important question, one that the Transaction Cost Pilot doesn’t even address: is the current highly automated US equity market structure contributing to volatility? The data seems to say “No”:
- In NYSE president Stacey Cunningham’s WSJ Op-Ed on Friday outlining the NYSE’s lawsuit against the SEC, she pointed out that last December saw 9 days when the S&P 500 moved 1% or more. She quoted Treasury Secretary Mnuchin in the first paragraph of her piece: “Market structure has led to a lot more volatility.”
- But… That same market structure was in place during Q4 2017 and Q3 2018, when the S&P 500 saw no 1% days in either quarter.
- And… You have to go back to Q4 1965 to find another quarter when the S&P 500 failed to move 1% or more on any given day in a quarter. Prior to that, the index was similarly calm in Q2 and Q3 of 1963 and Q1 of 1964.