Opening Remarks of
Remarks to the SEC Investor Advisory Committee discussion regarding
Stock Exchanges: Investor Protection Under the Modern Exchange Regulatory Structure
March 28, 2019
Thank you, Chairman Sheehan and Vice Chairman Walter for the opportunity to speak to the Investor Advisory Committee (IAC) about this important topic. My name is Brad Katsuyama, and I am the CEO and co-founder of the Investors Exchange, or IEX. How exchanges and exchange regulation treat investors plays a significant role in how well investors fare in our capital markets. This includes all investors and not just individual retail investors seeking to buy or sell 100 shares at a time. As Chairman Clayton said in a recent speech, institutions like mutual funds and pension funds represent many millions of individual Main Street investors. The SEC has rightfully made the welfare of “Mr. and Ms. 401k” a top priority, and IEX agrees with this decision.
In contrast, over the past two decades, it has become commonplace for the existing exchanges to treat investors as second-class citizens. This is plainly evidenced by the fact that on every major policy debate in the past few years, the three large exchange complexes -- NYSE, Nasdaq, and Cboe – always come down on one side of the argument, and the largest institutional investors and pension funds are on the other side. This includes the SEC’s transaction fee pilot, the recent debates on market data and connectivity highlighted at the SEC’s market data roundtable last October (Roundtable), and even IEX’s own exchange application.
Thankfully, the positive progress we’ve seen in market structure over the past year has been driven by the pension and institutional investment community exercising their rightful voice as one of the primary stakeholders of the public markets. But with exchanges doing everything in their power, including suing their own regulator, to try to block reform, it is critical for the IAC to join and stay engaged with other investor representatives in pressing for reforms that benefit all investors.
Exchanges are different from every other kind of participant in fundamental ways. As quasi-regulators, they have authority over their broker and market-maker members, which creates the potential to abuse that authority to further their own corporate interests. Exchanges are required to put quotes and trade information into the public domain, and to cooperate in consolidating that data. They are often the first and last sources of liquidity for investors. Brokers must be able to access all the major markets to obtain the best price for their customers as required by regulation. Because they are a primary source of price discovery and liquidity, their market data is critically important, and each exchange has a monopoly over the distribution of its own market data and the connectivity required to receive it.
This is why exchanges have always been subject to strict standards and close oversight by the SEC and why their rules are required to protect investors and the public interest, provide for reasonable fees, not allow unfair discrimination among brokers, and avoid burdening competition among brokers.
Exchanges have always been subject to high standards, but the ways they are organized and offer their services have changed radically over the last 20 years, and those changes have definitely not put investors’ interests first. The rise of electronic trading and actions by the SEC to create competition led to an inflection point for exchanges. They could choose to innovate on behalf of the investors’ interests or their own. Becoming public companies allowed them to adapt more quickly to a changing market environment but also narrowed the set of interests they were incentivized to serve.
We should not fault exchanges for wanting to make money like any other company. But we also need to realize that exchanges are different than any other company and under the law, they are held to a much higher standard.
Let me repeat this point: exchanges are different and must be held to a higher standard.
Over the past two decades, exchanges have learned to use and abuse rebates in tandem with their regulatory status to hold onto as much order flow as possible, while the execution quality for investors on their exchanges deteriorated due to speed and data disadvantages created by the exchanges. They learned to exploit their monopoly over market data and connectivity and adapted co-location practices to increase the fees required for direct access. They spawned and gained control over independent exchanges and learned how to exacerbate and exploit this fragmentation to maximize their total fees charged. And they kept control over the market-wide plans, especially the SIP plans, to maximize their control over the fees that they earn from those plans, and also to make sure the “public” data feed would become and remain a second-class form of data, so they could maximize the value of their more robust proprietary data products.
Fortunately, the SEC, under the leadership of Chairman Clayton and all the other Commissioners and Director Redfearn in Trading and Markets, have taken major steps to correct the imbalances that have tilted the playing field against investors. It is critically important that investors and the IAC remain actively engaged in bringing all these initiatives to completion.
Transaction Fees and Rebates
The rebate system hurts investors in multiple ways. Those who need access to immediate liquidity must pay the maximum take fee at the largest exchanges. But when investor orders are sent to rest on exchanges that pay a rebate, they are doubly harmed. The rebates typically are not passed back. Second, because brokers trading for investors don’t have the same speed advantages as other participants, investors wind up at the end of a long line, so if a trade happens at all, the price often moves against the investor immediately afterwards. IEX and other experts have documented the effect of this “adverse selection”, and the compounding effects of trades repeatedly executed at worse prices results in billions of dollars in additional costs to Main Street investors. The exchanges have every incentive to ignore this adverse selection problem because rebates allow them to hold onto transaction volume, which increases the value of exchange market data and connectivity products.
The toxic effects of this rebate system led to unanimous approval by the SEC of its transaction fee pilot, after years of consideration, beginning with the work done by, the Equity Market Structure Advisory Committee. The pilot received overwhelming support from over $10 trillion in assets under management and over 50 letters from buy-side firms and their representatives, including this Committee. The decision by the incumbent exchanges to sue the SEC to stop the pilot is yet another data point to show how the exchanges ignore the needs of investors, and an obviously desperate attempt to hold onto this system despite universal investor opposition to it and clear evidence of investor harm from it.
We hope this committee will speak forcefully that the pilot should move forward, without delay.
Market Data and Connectivity Fees
As Chair Clayton, Commissioner Jackson and Director Redfearn have said recently, we now have a two-tiered system of market data. On one hand, we have the public consolidated data feed (or SIP) that was meant to be the heart of the national market system, but which unfortunately has become mostly irrelevant to traders and to brokers who are trying to get best execution for their clients. On the other hand, the proprietary data feeds sold by each exchange –with more robust information and without the delays inherent in the public data feed – is simply a better and more robust version of that public data. The conflict is obvious to everyone but the exchanges, which is why the SEC is rightfully addressing this issue, by reconsidering what defines “core data” necessary for trading in today’s markets.
It became obvious to our team at IEX during the discussions at the Roundtable last October that this debate was largely obscured by the absence of any relevant data on what it actually costs exchanges to produce market data and connectivity. To fill that gap of information, IEX recently issued a study called, “The Cost of Exchange Services”, which details our costs to provide these necessary exchange services. In our report, we estimate that exchanges sell these products for mark-ups of up to 4,200% for connectivity and 1,800% for market data and other technology products required to access exchanges. Spreads at these levels are clearly the hallmark of monopoly pricing.
These fees hurt investors in multiple ways.
First, it is simple economic logic to understand that egregious overcharging of broker agents will result in higher average fees for the clients they serve.
Second, these markups directly impact investors that have trading strategies or investment strategies requiring their own subscriptions to market data products.
Third, these markups also substantially increase costs for small and mid-size brokers, and ultimately, this cost burden limits choice for investors. As Mett Kinak and Simon Emrich said at the Roundtable, their firms would not even consider giving business to brokers that don’t have access to proprietary market data from all the exchanges.
The exchanges’ only answer so far is that their “all-in” price to trade is reasonable, when you factor in all fees and rebates on an average per share basis. But they have also admitted that the rebate benefits go heavily to just a few firms. They won’t disclose the “all-in” cost for brokers whose main business is trading for investors, but we know from our experience that it is much higher than a well-functioning competitive market would allow.
One solution to this problem of over-charging the industry is more transparency. Exchanges, which enjoy special privileges, should also be required to make disclosures about their costs and revenues for products for which there is no practical alternative. IEX is working with the industry to propose a way that the SEC could require disclosure of exchange costs and revenues from all market data and connectivity costs. Beyond that, we support the steps outlined by Chairman Clayton and Director Redfearn to find ways to make the public data feed what it was originally meant to be – a way to level the playing field by making robust market data as widely available as possible.
We hope the IAC will also encourage and draw attention to these efforts.
The NMS Plans: Who Controls the Architecture
Investors are also hurt by the fact that they don’t have effective input into management of key parts of the market infrastructure – consolidated data operated by the exchange-controlled SIPs, the consolidated audit trail, and the limit up/limit down plan. The current structure for these plans, where only SROs have a vote, only makes sense if you believe that the SROs by their design will make decisions in investors’ best interest, and I would suggest anyone who believes that has not been paying careful attention to how these plans have performed.
I hope the IAC will join and stay engaged with other investor representatives and advocates in demanding voting representation of investors on all the national market system plans. After all, these markets are here to serve the needs of investors – so their exclusion makes little sense.
Some investors are also affected by poor liquidity in the trading for smaller-capitalization securities. A major source of that problem could be caused by excessive market fragmentation that I mentioned earlier. This is the basis for the proposal by some exchanges, also mentioned in Chairman Clayton’s recent speech, to allow the suspension of unlisted trading privileges (UTP) for the stocks of some issuers, and to give the listing market more flexibility in the rules that apply to trading in those shares.
There is no clear basis for thinking that prohibiting UTP by itself would increase the overall volume or liquidity of exchange trading of those stocks, it might even have the opposite result. And it would raise the possibility listing markets abusing their position as the only exchange where trading can occur. This is especially concerning considering the demonstrated ability of exchanges to abuse their position without this proposed status enhancement.
Investors have an enormous stake in how the current debates on exchange fee and governance practices are resolved. The legacy exchanges that have benefitted from business methods that harm investors are launching an all-out effort to block the reform efforts that are finally underway. The very fact of how hard they are fighting against the investor sentiment for reform shows how timely and important it is to move forward.
Thank you for the invitation to participate.