Smaller suppliers
Besides using special rebate programs to appeal to nontraditional players, the exchanges are also crafting programs to capture smaller suppliers or new customers.
While Arca chose not to base its rebate on the growth in a member’s posted volume for its Investor Tiers program, it did embrace the concept for its new “step-up” program. Arca launched the two-tiered program in July. It targets smaller and newer customers that might not qualify for the rebates in Arca’s other two programs.
Under the program, a firm must post more liquidity in a given month than it did in the baseline month of June 2011. Arca will pay 29.5 cents to firms exceeding their baseline levels by 0.15 percent of TCV. It will pay 29 cents to firms exceeding their baseline levels by 0.1 percent of TCV.
The deal potentially offers better terms than Arca’s standard program. Under the rules, a firm must post a minimum of 15 million shares in excess of their baselines to qualify for the exchange’s highest rebate. But the baseline itself has no minimum. That means a firm could simply post 15 million shares and qualify for the highest rebate. That compares favorably against Arca’s standard volume threshold of about 50 million shares necessary to earn the highest rebate.
Direct Edge launched a similar program in March on its EDGX platform, as a way for a trading firm to qualify for its Mega Tier rebate of 32 cents. Initially, a member had to post 15 million shares more than it did in the baseline month of February. To qualify, a firm had to have done at least 1 million shares in February.
The economics were considerably better than those of EDGX’s standard rebate program, where firms must post 0.75 percent, or more than 50 millions shares per day, based on July volume levels, to qualify for the Mega Tier rebate.
“As with any consumer business, we are offering price discounts for new customers-customers who are coming from a competitor,” Harkins explained. “Traditionally our rate cuts have rewarded fixed volume or liquidity provision over a period of time, but this is rewarding growth.” The exec added that the program should appeal to both large and small firms, both new and old customers.
To broaden the program’s appeal, EDGX later chopped that 15 million-share threshold down to 0.12 percent of TCV. That was about 8.4 million shares per day based on July’s volume. The exchange also eliminated the million-share baseline minimum. And to make it even easier for smaller suppliers to participate, EDGX added a second tier. From July, it began paying traders a 29-cent rebate if they exceeded their February baseline by 0.065 percent of monthly TCV. That was only 4.5 million shares at then-current levels.
The step-up programs don’t work for everybody. Lime, for example, offers its customers self-directed routing. The high-frequency traders route their orders to whichever venue suits them at the moment. That precludes Lime from steering its orders to a single exchange. “In the world of high-frequency trading,” Jacobs said, “you really need to have access to all markets. If you hit the step-up volume level, it’s really more from happenstance than intent.”
BATS’s Shift
While Direct Edge is an inveterate tinkerer, revising its price schedule every month, BATS has traditionally kept things simple. For most of its existence BATS had only one pricing plan and no tiering. It boasted of its “flat” pricing model, and its aversion to the programs of its competitors that rewarded the biggest traders at the expense of the smaller ones. That has all changed.
In July, BATS tiered the rebate on its flagship BZX exchange. Now, for those traders that post 1 percent of TCV, or 70 million shares per day at July levels, BZX will pay its highest rebate of 29 cents per 100 shares. If they post at least half that, BZX will pay 27 cents, previously its standard rebate. The lowest rebate is now 25 cents.
Tiering generally works to the advantage of the largest players. That’s because they earn more on every share than they did before tiering. At BATS, for instance, a firm supplying 70 million shares per day received 27 cents before tiering. Now it gets 29 cents.
As part of the restructuring, BZX launched a new program with an additional rebate. The so-called “NBBO Setter” program was originally deployed in BATS’s options marketplace, where it was a “hit,” according to chief executive Joe Ratterman. The goal of the program is to encourage firms to post large amounts of liquidity, and also to tighten up the exchange’s markets by establishing the national best bid or offer.
The heart of the program is a sweetener rebate similar to the one Nasdaq offers in its Investor Support Program. To qualify for the add-on, a member must post a daily average of at least 0.5 percent of monthly TCV in liquidity and set the NBBO.
If it does, a firm will receive 2 cents on top of BZX’s best or second-best rebate. For the largest traders, that means 31 cents. It is the highest rebate in the Kansas City, Mo.-based exchange’s history, and reflects a rebate “creep” at BZX that began late last year.
In a note to customers, chief executive Joe Ratterman called the introduction of NBBO Setter a “paradigm shift” for the exchange operator, as it had previously stuck with an untiered pricing model. Ratterman claimed the move was not about rewarding the biggest shops. “We aren’t just directing better economics to clients because of their size,” he told members. “We are also directing incentives to them based on their actions, specifically those actions that can actually improve market quality.”
More Tiers
BZX isn’t the only exchange to tier an older program this year. Back east, both Nasdaq and the NYSE have also tiered long-standing programs. In January, the New York Stock Exchange introduced tiered pricing for a key group of trading firms, the so-called Supplemental Liquidity Providers.
There are 10 SLPs. They include major market makers such as Tradebot Systems, Virtu Financial, Hudson River Trading, Getco, Citadel Securities and Knight Capital Group. They wield enormous influence with all exchanges, as they are significant suppliers of liquidity to them. Knight and Citadel have stakes in Direct Edge, for instance. Tradebot and Getco own pieces of BATS.
Before January, all SLPs got the same amount: 13 cents per 100 shares. To make quoting on the NYSE more attractive, the exchange boosted its lowest rebate to 15 cents and added three tiers. The traders, which provide about 15 percent of the exchange’s liquidity, can now earn between 20 and 22 cents, depending on how much volume they contribute. To get the highest rebate, they need to post 50 million shares per day, on average.
As for Nasdaq, it tiered a rebate program that rewards big traders on both its flagship stock market and the Nasdaq Options Market. The pricing program, begun in 2009, previously paid traders a 29-cent rebate if they posted 25 million shares on Nasdaq and traded 200,000 options contracts on NOM. Since April, Nasdaq has added two tiers to the program, a 25-cent and a 29.5-cent rebate. In addition, Nasdaq reduced the thresholds necessary to qualify for the 29-cent rebate. Firms now need only post 0.15 percent of TCV at July volume level, or about 10 million shares, and trade 115,000 options contracts.
The Impact
So what’s been the impact of all this maneuvering around rebates on the exchanges themselves? If more rebating is good news for brokers, is it bad news for the exchange’s financial health? And what about market share? Who’s up? Who’s down?
Of the volume available to the exchanges-flow that is not internalized-the five largest maker-taker exchanges control about 85 percent. That was the situation in July as well as December 2010.
Perhaps it’s not surprising that the most aggressive cost-cutters have seen upticks in their market shares. The others have seen their shares decline.
Between December and July, Nasdaq, BZX and EDGX saw their shares of the pie grow. The New York Stock Exchange and Arca experienced declines (see table).
Paying for market share comes at a cost, however. In last year’s fourth quarter, Nasdaq earned $37 million in net revenues attributable to U.S. cash equity trading. It made slightly less-$36 million-in this year’s second quarter. Net revenues are the spread between what an exchange takes in from traders and exchanges and what it pays out to traders and other exchanges.
By contrast, NYSE Euronext earned $47 million in U.S. stock trading net revenues in last year’s fourth quarter. It netted $51 million in this year’s second quarter.
Those figures cover all shares handled, not just matched, across all of the exchange operators’ U.S. venues. They do not include market data revenues.
Interestingly, Nasdaq processes roughly twice as many shares as NYSE Euronext, but earns half as much on each share. Thus its “revenue capture” rate-net revenues divided by shares handled-is half that of NYSE Euronext’s.
NYSE’s revenue capture per 100 shares rose between last year’s fourth quarter and this year’s second quarter from 3.26 cents to 3.9 cents. Increasing the profitability of every share is the goal, NYSE execs have been telling analysts and investors for the past two years. For Nasdaq, its capture rate was unchanged during the period at about 1.6 cents.
Despite Direct Edge’s aggressive pricing habits, Harkins says the exchange operator does not run its business at a loss and strives to bring as many traders to its platform as possible.
“There are other ways to monetize people coming to your exchange,” he said. “That’s why you’re seeing exchanges diversify. Size and legitimacy and being a place for price discovery are really essential for that strategy.” Direct Edge tries to steer its customers into ancillary services such as its connectivity program, Harkins added.
Whether or not the exchanges will keep up the intense level of rebate competition remains to be seen. But at least one analyst believes prices have only one direction to go, and that’s up.
Diego Perfumo, a financial analyst with Equity Research Desk, maintains that market share gains from aggressive pricing are easily lost. He points to Nasdaq’s beating in recent years at the hands of BATS and Direct Edge. Nasdaq made market share gains in NYSE-listed securities at the expense of the Big Board after Regulation NMS went into effect, but later saw them siphoned away by the two upstarts.
“If we continue to see this anemic volume,” Perfumo said, “you will see prices going up. Either that or they won’t be making any money at all and will have to get out of the business.”
