The New York Stock Exchange's dramatic reconfiguration of its pricing structure last summer proved to be a boon for Nasdaq. The all-electronic market, using an aggressive pricing scheme, captured the listed business of more than 150 broker-dealers fleeing significantly higher prices at the New York. Nasdaq now sends a half-billion shares to the NYSE every day, up from 200 million per day in the first quarter of this year. Nasdaq's broker-dealer subsidiary is the Big Board's biggest liquidity provider, shipping the exchange almost twice as many shares as does
Merrill Lynch, the second-biggest NYSE broker.
But this summer's drama may prove to be only the first act in a longer play. The Big Board's pricing move, its first major change in decades, is looking more and more like an opening volley. Subsequent tweaks and the expectation of more change suggest that Nasdaq's advantage may not last.
Currently, Nasdaq routes more than 20 percent of its daily captured order flow non-stop to the NYSE. The remaining 400 million shares first pass over Nasdaq's order book. That has increased Nasdaq's matched market share for NYSE-listed equities to 13.4 percent in October, up from 10.8 percent in July, before the New York's new pricing went into effect. That figure was 5.7 percent in October 2005.
NYSE Group's market share for NYSE-listed trading was 69.2 percent in October, down from 78.6 percent a year earlier. It was 72.6 percent in July.
Fee Caps
But Nasdaq's ability to profit at the NYSE's expense may be short-lived. Nasdaq benefited from the NYSE's August elimination of one fee cap for customers and its adjustment of another. The NYSE can-and, some industry observers say, will-soon change its pricing to counter Nasdaq's belligerent forays onto its turf.
At issue is the NYSE's current $750,000 monthly cap for big brokers' transaction fees. The cap has enabled some of the exchange's largest member firms, including Nasdaq, to provide cheap NYSE access to smaller firms that don't meet the cap.
Observers now anticipate that the NYSE will eliminate the $750,000 cap and alter its pricing. That would prevent NYSE's competitors and customers from grabbing orders before they reach the exchange and potentially executing against them. These large firms could wind up paying significantly more without the cap, but the exchange is likely to take measures to lessen their pain, perhaps by lowering or tiering certain transaction fees. The exchange could also institute different pricing for liquidity takers and liquidity providers, which is currently not the case. In mid-November, rumors about the elimination of the cap had increased on the NYSE floor.
Richard Rosenblatt, founder and CEO of agency broker Rosenblatt Securities, says the NYSE Group "is finally getting its pricing right-and it's only a matter of time before the dollar cap disappears." His firm has had an NYSE floor operation since 1979 and has traded Nasdaq stocks upstairs since the mid-'80s.
"For the first time in a while, we think the NYSE could gain back market share," Rosenblatt says.
New York's Gamble
Until August, the exchange gave its broker-dealer customers three payment options for their transactions. They could pay a volume-based variable rate, they could pay 2 percent of their net monthly commissions, or they could fork over $600,000 per month. Most firms chose the 2 percent option, with only the largest opting for the dollar cap.
The NYSE eliminated the 2 percent cap in August. It also switched to a fixed charge of 2.5 cents per 100 shares for both liquidity takers and liquidity providers, and raised the monthly cap to $750,000.
But while the NYSE's transaction pricing went up, the exchange remained the cheapest place to take liquidity in its own listed securities-and it had the deepest markets. Its takeout fee of 2.5 cents per 100 shares was significantly lower than Nasdaq's 7 cents per 100 shares. (NYSE Arca's take charge was 10 cents per 100 shares in the summer, but is now double that.)
However, it was the lifting of the 2 percent cap that proved to be the catalyst for the ensuing pricing battle between NYSE Group and Nasdaq.
The NYSE got rid of the cap because it hurt the exchange's profitability. Firms paying under that cap did not pay the NYSE proportionally more as volumes rose-and volumes have been rising.
"The 2 percent cap was limiting our growth and allowing companies to essentially trade with us for free," says Gary Stein, vice president and head of NYSE Group's investor relations. "Now we're better positioned to gain revenue as volumes grow."
However, the NYSE's dollar cap gave the exchange's largest customers an opportunity to compete with the exchange by offering discounted DOT routing to smaller brokers that didn't meet the dollar cap. A handful rolled out "mini-caps" that provided cheaper access to the NYSE than the firms could get directly through the exchange.
Cheap Access
Nasdaq was the most aggressive on this front, according to market participants. Nasdaq Execution Services, the exchange's broker-dealer subsidiary, saw its monthly bill soar, along with most other brokers. It had paid the NYSE under the 2 percent cap. With the elimination of that cap, Nasdaq now pays the Big Board $750,000 per month, or $8.9 million per year.
Nasdaq extended its routing capability to smaller brokers and gave them discounted access to the New York. Its goal was to use its pricing and routing fees to increase its market share through matched liquidity on its own book.
In August, Nasdaq began charging customers 2 cents per 100 shares for orders routed to DOT if those orders first checked Nasdaq's books, with a monthly cap of $60,000 for NYSE-executed orders. Customers could also route directly to the NYSE through Nasdaq's pipes for 2 cents per 100 shares with no cap.
The program worked and many firms shifted their routing to Nasdaq. That drove up Nasdaq's internal matched rate and increased its transaction revenues. Nasdaq was getting 7 cents per 100 shares for liquidity removed from its book, while unfilled orders were sent on to the NYSE at no cost to Nasdaq.
"The benefit to customers of paying the premium price [on Nasdaq] is quick electronic execution before the order goes down to the specialist," says Brian Hyndman, senior vice president for Nasdaq transaction services.
Action-Reaction
NYSE Group didn't sit still-and the battle has since gotten fiercer. In a classic pincer movement, NYSE Group squeezed Nasdaq by altering the pricing structure on NYSE Arca. The NYSE was already the cheapest place to execute listed stocks. In September, the company changed Arca's pricing to best Nasdaq on the rebate side, starting in October. It offered-for the first time-a rebate of 20 cents, compared to Nasdaq's high of 6 cents, per 100 shares. The takeout charge on Arca became 30 cents per 100 shares.
Nasdaq immediately replied by offering to route customers' listed flow that didn't match on its own book to Arca for 28 cents per 100 shares. If that move attracts volume, it could increase Nasdaq's market share of matched volume.
In any event, the Arca move may have been successful. Arca's matched and routed market share for NYSE-listed stocks was 9.3 percent in October, up from 8.4 percent in September (the figure excludes exchange-traded funds, or ETFs). It was 5.2 percent in October 2005. Arca does not separate out its matched and routed market share.
In late September, the NYSE announced it would charge customers for equities orders routed through the NMS linkage plan to other markets the same amount it charged them for executions on the New York's book (ETFs, in both cases, would be charged 30 cents). That meant NYSE customers whose orders were not filled or price-improved on the NYSE would pay less to take liquidity on Nasdaq or Arca than if they went directly to those markets.
Nasdaq immediately offered to route out orders-including ETFs-through the NMS linkage plan to the NYSE for 7 cents per 100 shares, and to Arca for 28 cents per 100 shares.
Nasdaq continued turning up the heat. Starting in November, to entice more brokers to use its broker-dealer subsidiary to get to the New York, thereby increasing its own match rate, Nasdaq dropped its monthly cap for orders that first check Nasdaq's book to $25,000. Orders routed straight to the Big Board got a $75,000 monthly cap.
"We thought if we lowered the cap to $25,000, more firms would use it, volume over our book would increase, and hopefully we'd get more executions on our book-which is what we've seen happening," Hyndman says.
Big Penalty
More telling was Nasdaq's announcement on October 19 (when it also announced the new caps) that it would raise its take charge for customers adding less than 100,000 shares of monthly liquidity to its book from 7 cents to 30 cents per 100 shares. This meant customers only routing orders to Nasdaq, without initiating volume on its platform by posting limit orders, would get stuck with much bigger bills.
On November 1, the day that pricing schedule was to go into effect, Nasdaq backed off and switched its take fee to a 7-cent/10-cent/15-cent structure based on the amount of liquidity added.
Nelson Chai, NYSE Group's chief financial officer, provided some color on this decision at a Keefe, Bruyette & Woods conference in early November. He said Nasdaq's pricing plan imposed a "huge penalty if you didn't provide any liquidity, and the only people really impacted by that were us and the other exchanges. And the SEC actually stopped that…-at least, temporarily." The SEC declined to comment about this.
Battle-Ready
The all-swords-drawn pricing-and-routing battle is set to continue as the full implementation of Reg NMS approaches and as other exchanges jump further into the listed game.
NYSE Arca's hefty-rebate pricing could also gain more sway and influence the course of listed pricing. Some industry watchers expect the NYSE to eventually veer toward an electronic communications network-like take/rebate pricing structure.
For its part, Nasdaq is now watching two fronts. "We'll keep an eye on what's happening at the NYSE and Arca, and if we need to move to a more aggressive rebate model, we'll do so," Hyndman says. "But I currently don't see market share moving away from us." He adds that no matter what happens with the NYSE's dollar cap, Nasdaq "could still route out at a discount, like we do today with Arca."
However, the NYSE is equally bent on getting that first look at incoming orders-and is willing to eat the cost of routing out to markets that charge more than it does if it cannot execute orders on its own book. Since other exchanges charge more than the NYSE's 2.5-cent fee for 100 shares, it could rapidly bleed money with this policy.
But it's probably worth it, says agency broker Rosenblatt. In his view, "the exchange is betting that with its liquidity and price improvement, if the order comes to its book, it will never leave the exchange."
Pricing Structure
For Nasdaq-listed securities, the pricing structure for trades settled into a 20/30 model in recent years-a rebate of 20 cents per 100 shares to firms adding liquidity that gets executed, and a charge of 30 cents per 100 shares to firms that take liquidity. New electronic communication systems building volume may dart in and tighten the spread by offering larger rebates or lowering the take charge, but the broader add/take structure remains in place.
In the listed world, there's no single approach to pricing. As long as the NYSE centralized liquidity and offered the bulk of the price discovery, that was where traders went to execute their orders. The New York's fees were also the lowest-and that made other pricing structures largely irrelevant.
But the NYSE's for-profit status, the rollout of its hybrid market and the upcoming implementation of Regulation NMS have fueled competition in listed securities. As the Big Board's historical stranglehold on market share loosens, alternative pricing structures could become more appealing.
Big vs. Small Brokers: The $750,000 Question
The New York Stock Exchange's unprecedented pricing changes in August bruised floor traders and small- and mid-tier brokerage firms the most. Ted Weisberg, president of floor broker Seaport Securities Corp., says the disappearance of the 2 percent cap affected people on the floor differently, but that "smaller firms that paid under the cap have clearly been negatively impacted." Weisberg, who founded Seaport in 1979, has been on the floor since 1969.
The Organization of Independent Floor Brokers (OIFB), which has 250 members, also stressed that smaller brokers got hurt by the pricing overhaul.
"Many independents are experiencing increases in their transaction fees in excess of 100 percent-and some exceed 300 percent," says Michael Rutigliano, director of floor trading at W.J. Bonfanti Inc., and vice president of OIFB.
A larger complaint was that the NYSE's pricing increase was distributed unfairly across firms. The largest 20 or so Wall Street firms sending order flow to the NYSE that paid the exchange under the dollar cap saw their monthly fees rise 25 percent, but the marginal cost above the cap was zero, critics say. As volume increased for those big brokers, their average per-share fee decreased.
Those that couldn't reach the dollar cap, on the other hand, simply got a fee hike. The dollar cap therefore put them at a disadvantage in their competition with large broker-dealers for customer orders.
Simply removing the cap would end the ability of bulge-bracket firms to benefit from a lower effective rate, says Rutigliano. But that could also involve risks for the exchange.
"The large firms will always seek low-cost executions, and their investments in regional exchanges and electronic marketplaces may make it easier for them to redirect their business-and that would be detrimental to the NYSE and its trading floor," Rutigliano says.
