Regulatory scrutiny of US market structure is intensifying, reinforcing the imperative for stock exchanges to look beyond matching equity trades towards new innovations and revenue diversification.
Recently, the Securities and Exchange Commission (SEC) rejected Nasdaq OMX’s proposal to establish a benchmark order plan and the agency has also deferred decision on whether to approve the bourse’s retail price improvement plan.
Such judgements suggest a growing reluctance by the watchdog to approve functionality which contributes to market complexity. Nonetheless, overall revenue opportunities from secondary trading continue to decline at many exchanges.
“The potential for revenues from equity markets has shrunk drastically over the last three years and continues to do so,” said Sang Lee, managing partner at consultancy Aite Group. “New retail programmes and order types are all well and good, but they still target an area of the market that continues to decline.”
The agency’s disapproval of the benchmark order plan – which offered exchange-level algorithmic strategies such as VWAP and TWAP – was the first time the SEC had prohibited an exchange from launching new order types. The move supports the view that regulators and market participants see US market structure as too complicated.
Nasdaq OMX is yet to state whether it plans to appeal the regulator’s decision. In its pronouncement, the SEC voiced discomfort over potential immunity that Nasdaq OMX could enjoy a self-regulatory organisation (SRO); if liability were to arise because a market participant lost money using the new order type, Nasdaq OMX could theoretically hide behind its SRO status in a way a broker could not. The agency also questioned the plan’s compliance with a recent rule requiring all orders to be screened before they hit the market.
Putting the buy-side in the slow lane?
Concerns over order type complexity were also raised last year when NYSE Arca launched its PL Select order type, which does not interact with immediate-or-cancel orders, intermarket sweep orders or orders larger than the originating trade. Although the order type was approved by the SEC, market participants believed the functionality benefitted high-frequency traders at the expense of institutional investors.
“We believe that this and similar other proposals unnecessarily segment clients to the detriment of long term investors and erode confidence in a fair and orderly marketplace,” read a submission to the SEC from Baltimore-based asset manager T Rowe Price’s heads of trading and senior legal counsel.
Exchange providers are also trying to increase revenues and flow from retail participants by providing more retail-friendly environments. Nasdaq’s retail order plan – still being assessed by the SEC – would create a new retail member organisation designation. The new membership category would offer price improvement for retail flow over the national best bid or offer. NYSE Euronext (currently the subject of a takeover bid from IntercontinentalExchange) and BATS Global Markets have recently announced similar initiatives.
As exchanges continue to explore every possible avenue for new sources of income, they have found themselves weighing in on the debate over market complexity.
“If we want to reduce the complexity of technology and our markets, we should simplify the overall market structure,” said Joe Mecane, head of US equities, NYSE Euronext, at a Senate Committee hearing on computerised trading last December. “Doing so would certainly prove beneficial for the future of our national market system, for investors and issuers, and to the growth and well-being of our economy – including efficient access to capital to fund innovation, new business and job creation.”
With this in mind, exchanges have accelerated the rollout of new technology services. Earlier this month, Nasdaq OMX announced plans to combine its market technology and corporate solutions businesses with the aim of driving growth across its technology businesses, including the provision of trading platforms to other exchanges across the globe.
The bourse has also made a number of acquisitions to enhance its transaction services and data businesses. These include the 2010 purchases of market surveillance firm SMARTS and FTEN, which offers risk management tools. More recently, Nasdaq teamed up with Amazon Web Services to launch FinQloud, a new solution to help market participants cost effectively manage and store financial data to meet regulatory requirements.
Similarly, in the exchange’s last earnings call, NYSE Euronext identified technology growth through deployment of its matching technology to other areas and through the extension of data services, as a key part of its strategy.
Whether these types of services offer a meaningful diversification of income remains to be seen.
“The question is whether technology revenue is enough to keep up with the decline in cash equities trading revenue,” said Lee. “It’s a good business with potential but at the end of the day technology is a value-added service and not part of an exchange’s core business.”