How can market makers remain competitive in a hostile trading environment?
They can capture the value of processing customer order flow and charge for the unique aspects of their liquidity services. A good place to start is with the quotation and last-sale information-value of order flow.
Historically, market makers relied exclusively on the bid-and-offer spread to cover the cost of all services they provided to retail brokers.
These services included leased communication lines to clients, computers and software, correspondent fees paid to brokers, publication of quotations, order execution and trade processing, inventory risk and compliance.
Times have changed, of course. The Securities and Exchange Commission-approved order handling rules have essentially eliminated the ability of market makers to capture the spread-revenue on limit orders.
These rules give priority preference to limit-order quotes over pre-existing market-maker quotes, requiring the inclusion of limit-order prices in the National Best Bid and Offer. Consequently, the rules have narrowed market-quoted spreads by about 25 percent.
Regulation, in effect, has forced an unbundling of market-maker revenues. Through a matrix of rules, the SEC is actually keeping market-maker spreads on market orders at a level not exceeding the cost of providing the liquidity services of a limit-order book. Unfortunately, these limit orders cover none of the market makers' regulatory costs.
In contrast, market-maker regulations, such as mandatory SOES and fixed minimum quote sizes, are still in place, forcing market makers to keep extra, costly liquidity services bundled with their quotations. A market-maker quotation is now worth more than an incoming customer limit-order quote, yet the market maker cannot provide these liquidity services exclusively to customers. A competitor, for instance, could hit the market-maker's bid via SOES.
Market makers initially responded to the order handling rules by reducing expenses, specifically eliminating cash payments to retail brokers for unprofitable limit-order flow. Of course, this shifted a significant part of the immediate negative revenue effects of the rules to retail brokers and their customers. Still, market makers are executing limit orders at a loss.
Now they must find new ways to remain competitive. Last-sale information-value of order flow is worth examining.
To begin with, National Market System (NMS) facilities have been allowed to evolve in a manner that requires information-generating enhancements such as last-sale reporting on Nasdaq stocks to increase participants' operating costs. The value of the information is captured by the self-regulatory organizations (SRO) through exclusive management of the central-information processor. Nasdaq is an example of an exclusive central-information processor.
The Chicago Stock Exchange (CHX), as an SRO participant in the unlisted trading plan for Nasdaq stocks, is able to share in the huge subscriber-fee revenues generated by the National Association of Securities Dealers from the sale of last-sale and quotation-price data. In 1996, NASD market-data and subscriber-fee revenues aggregated $222 million.
Market makers and electronic communications networks (ECN) should have as much interest as the CHX in capturing the market-data value of their order flow. After all, they are the producers of the quotation and last-sale information that is being sold.
Therefore, it would only be fair to reconfigure activities to capture an equivalent proportion of the market-data revenues on the same basis as the CHX. As I previously stated in Traders Magazine, the current arrangement for sharing market data subscriber-fee revenues among SROs (exchanges and the NASD) is unfair, placing market makers and ECNs that are not SROs at a competitive disadvantage. It discriminates against small-investor clients, who unlike institutional investors, are dependent upon the ability of retail brokers, market makers and ECNs to achieve the revenue and cost efficiencies derived from the aggregation of small orders into a large flow.
Such discrimination appears to violate the spirit of the NMS 1975 Amendments to the Securities Exchange Act of 1934. Congress was explicit regarding its intention that the SEC apply rigorous utility-type regulation to insure the competitive neutrality of the NMS facilities characterized by exclusive SRO processor control. Through regulatory oversight, the NMS plans have allowed the NASD to retain the market-maker share of subscriber-fee revenues for both Nasdaq and New York Stock Exchange-listed stocks.
Similarly, the discriminatory impacts of subscriber fees and sharing deficiencies on individual investors, investing directly, have been overlooked.
Clearly, the costs of the central processor need to be covered. But subscriber-fee revenues, not required for the receipt and redissemination of the information to vendors, should be apportioned among the generators of the information in relation to their contribution to the value of the information stream. A method is required for non-SRO trade-execution centers to capture their proportionate share of market-data revenues. For one thing, the SEC could require changes in NMS plans that enable non-SRO quotation and last-sale reporting centers to participate on the revenue-sharing side. For another, market makers could explore ways to route their quotation and last-sale information through an SRO that agrees to share revenues, or is set up to accomplish that objective.
Market makers and ECNs owe it to themselves and their clients to capture that value. With only 50 market makers and ECNs accounting for almost 95 percent of Nasdaq and third-market transactions, this should not be an insurmountable task.
Gene L. Finn served as chief economist for the SEC and the NASD. He is currently an outside director at Ameritrade Holding Corp. and Roundtable Partners.
