The battle for a wholesale review of how exchanges charge their customers ramped up as the exchanges moved to legally stop an upcoming SEC transaction fee pilot program before it begins.
The unified opposition from New York Stock Exchange, Nasdaq and Cboe Global Markets Inc. is matched by equally passionate pension fund officials, money managers and other investors who see a lot riding on the pilot program's potential to shed more light on exchange practices and costs.
"We would suggest that the results from the transaction fee pilot can serve to initiate a broader discussion on the appropriate reward model for exchanges," wrote officials from Norges Bank Investment Management, the manager of the 8.6 trillion Norwegian kroner ($1 trillion) Government Pension Fund Global, Oslo, in a May comment letter.
New York City Comptroller Scott M. Stringer, fiduciary for the $193.7 billion New York City Retirement Systems, agrees. "When we put transparency first, everyone benefits. The SEC's transaction fee pilot will show what's behind the curtain to reduce potential conflicts of interest risks in the current 'maker-taker' model and bring down the cost of investing,” he wrote in an email.
The Securities and Exchange Commission approved the two-year transaction fee pilot program Dec. 19 to measure the effects of maker-taker rebates on equity trade execution, with the goal of studying the results on routing behavior, execution quality and market quality.
Maker-taker rebates refer to the practice of exchanges paying rebates to some broker members for order flow.
Waiting on a date
The start date has not been set for the pilot, which will separate equities into one of three groups. One will be a control group of the current cap-free trade regimen. Another group will bar exchanges from offering rebates and linked pricing; the third group will test a fee cap of 10 cents per 100 shares traded. Also as part of the pilot program, national exchanges would have to publicly post their transaction fee and rebate data monthly.
The exchanges are challenging the pilot program on several points, and warning that it has the potential to harm both investors and publicly listed companies. (see related story on page 20.)
NYSE's Feb. 15 petition for review to the U.S. Court of Appeals for the District of Columbia Circuit argued that the rule is unlawful under the Securities Exchange Act of 1934 and the Administrative Procedure Act, calling it “arbitrary and capricious” and asserting that SEC officials overstepped their authority.
The lawsuit was a last resort, filed after efforts to compromise with the SEC on an alternative approach failed, NYSE officials said in an email. A Cboe spokesman said, “The pilot is so intrusive, ill-conceived and likely to harm the equities markets, there was no choice.”
One criticism raised by the exchanges is that the pilot does not include off-exchange venues, which could potentially gain an advantage. While that could happen, “if flow does shift to these venues, it would be a confirmation that rebates influence routing behavior,” Richard Johnson, vice president for market structure and technology with Greenwich Associates in Stamford, Conn., wrote in a February commentary on its website.
“The debate around fee structure and maker-taker pricing has raged in U.S. equity markets for many years, and it is important that we move to a resolution,” Mr. Johnson said.
Exchanges also worry about the complexity and costs to all market participants in implementing the pilot. Joe Wald, CEO of agency broker Clearpool Group in New York, which represents primarily regional firms, thinks it will be “a non-event. This is just a configuration setting on our platform.”
“This pilot's real objective is to ensure that people really understand how these exchanges operate,” Mr. Wald said. “The awareness has definitely flowed all the way up to the asset owners, including pension funds. A vast majority of them are very interested in seeing what's going on.”
Even with the transaction fee pilot in at least temporary limbo, institutional investors are not giving up their pursuit of transparency that leads to reform.
When the SEC asked for comments on the transaction fee pilot idea last year, one of the loudest responses came from the public pension fund community. A letter spearheaded by the California Public Employees’ Retirement System and the C$193.9 billion ($145.2 billion) Ontario Teachers’ Pension Plan, signed by U.S. and Canadian public pension funds and asset owners with a combined $1.4 trillion in assets, showed support for the pilot program, citing their “deep interest in market structure reform.”
Don Pontes, investment director for financial markets with $351.1 billion Sacramento-based CalPERS, said he focused on teaming with institutional investors that either had substantial internal market operations or were in the process of building them and are becoming increasingly vocal about their ability to achieve best execution in the marketplace.
CalPERS has an estimated 83% of equities and more than 90% of fixed-income investments managed internally.
“Philosophically, we believe in the motives behind the letter: that exchanges should not be giving discounts” to some brokers, said Hank H. Kim, executive director and chief counsel of the National Conference on Public Employee Retirement Systems in Washington, another letter signatory. “Having a market that’s free of rebates is the more equitable way to proceed.”
While institutional investors may have to change course and pursue other avenues of market reform, CalPERS’ Mr. Pontes credits SEC officials for keeping a spotlight on it and encouraging feedback from the pension fund community on market structure issues in general.
When it comes to market structure reform, “I am extremely encouraged by the pace and the progress under the current commission. We’ve seen a tremendous effort,” Mr. Pontes said.
“The reality is that exchanges and big banks have been very vocal for quite some time. I am really encouraged that the pension community is getting a voice,” he added.