May 15, 2020
Last week, the SEC issued an order instructing US Equity Exchanges* and FINRA to come up with a proposal within 90 days for a new single National Market System for producing and governing consolidated market data. As with all new market regulation, this initiative will take some time to have an impact, and it could just fizzle. On the other hand, it is quite possible that it will throw a huge wrench in the obscure world of US equity market data. Eventually, it could have a profound, transformative effect on the industry.
The public mission of the consolidated plan according to the SEC order is to provide a “comprehensive, accurate, and reliable source of information for the prices and volume of any NMS stock at any time during the day.” The order denounces how “conflicts of interests” have arisen among the NMS participants primarily due to exchange consolidation. The order then explains how those conflicts of interest and inherent inefficiencies have damaged the current model (established in the 70’s), which relies on three separate Equity Plans: The NYSE-administered CTA and CQ Plan, the NASDAQ-administered UTP Plan and one centralized feed administered by the Securities Information Processor (SIP). The SIP links all the U.S. equity markets by processing and consolidating all protected bid/ask quotes and trades from every trading venue into a single, easily consumed data feed. Xignite makes the consolidated SIP data available in our delayed and real-time equity quotes products.
In its order, the SEC essentially denounces the side effects of the old structure and how it has encouraged the exchanges to develop proprietary products that are better than the SIP (for example products offering more depth of trading and lower latency like the NASDAQ and Cboe products Xignite offers).
The SEC further states that the exchanges are not incented to invest in the SIP as their proprietary products are much more profitable. Between the lines, the SEC seems to imply that while the exchanges have tried to improve the SIP, they have been somewhat disingenuous in those efforts so as not to hurt their proprietary products revenue streams. And as the order walks through the various comments provided by the market participants on a previous proposal of the order, it seems clear that exchanges opposed the order proposal while banks and brokers supported it.
However, to understand the true root cause of the “abandonment” of the SIP by the exchanges, one must look deeper into the mechanisms of revenue allocation for the SIP revenue. Market data revenue is critical to exchanges. The exchange business itself has become extremely competitive and low margin over the years. As they demutualized, exchanges have relied on the development of new revenue streams to grow their business. Market data is the most profitable part of an exchange business (as the data literally “exhausts” from the core matching engines).
The SIP represents a significant source of revenue for an exchange--although its share of the market has decreased as proprietary products have been developed. In 2017, the SIP revenue was $387M, down from $429M in 2007 according to the SEC. The SIP revenue is collected centrally and then allocated and redistributed to each exchange participant based on a set of rules.
Prior to 2007, SIP revenues were allocated in proportion to the number of trades reported by each exchange. The SEC established a new revenue allocation formula which went into effect on April 1, 2007. After this change, revenue was allocated based on:
This was at a time when new market participants were emerging with a focus on the then exploding demand for high-frequency trading. Newer participants (such as INET (the feed of which Xignite built its first real-time REST API back in 2003), BATS Trading, IEX and others) greatly benefited from this new cost allocation formula. Their market share (of trades) was relatively low, but their liquidity (quotes) offering was high due to the high-frequency nature of their clients and systems. Meanwhile traditional markets like NYSE and NASDAQ had many trades and high share volumes, but their quotes (sometimes still floor-driven) were less frequent.
The net result is that the large exchanges saw an immediate drop in their SIP revenue as a larger share of the revenue went to smaller or emerging exchanges. The rest is history. NASDAQ launched its first proprietary product (NASDAQ Last Sale) in 2008 and Xignite was the first market data vendor to support it. Other exchanges followed and today, all are understandably pushing their proprietary products. So as we see it, 2007 was the pivotal year for the SIP. And that change in how the SIP revenue was allocated sealed the destiny of the SIP itself.
The three charts below--extracted from “Understanding the Market for U.S. Equity Market Data” by Charles M. Jones from the SEC (published August 31, 2018)--clearly show how dramatically revenue allocation shifted from 2007 to 2018 from the main exchanges to the smaller ones.
One may even wonder if emerging exchanges like IEX would even exist if it were not for their disproportionate allocation of the SIP revenue given their low market share. That revenue is probably what has allowed them to offer their proprietary feeds for free and finance their entry into the data business.
So where do things go from here? In its order, the SEC suggests that the participants recommend a new way to allocate revenue in a fair fashion.This is likely to create much turmoil among participants as some may see critical revenues dry up while others may lose the incentive to push proprietary products after making huge investments in them.
Assuming that the new proposal reallocates revenue more fairly, what will be the impact? Will IEX be able to continue offering its proprietary feed for free if it loses much of its SIP revenue? Will NASDAQ and Cboe continue to push BASIC and Cboe One respectively if the share of revenue they receive from the SIP better reflects their contribution to execution and price discovery? Will the newly approved exchanges (LTSE and MEMX) be able to get off the ground without that disproportionate allocation of revenue that really helped get others (like it helped get BATS Trading (acquired by Cboe), DirectEdge (acquired by BATS), and IEX) off the ground)? At the end of the day, will market data consumers and investors benefit--as is the intent of the SEC with this order?
Exchanges have 90 days to make the new proposal to the SEC. That’s not a lot of time for a supercharged topic like this. Because SIP revenue allocation will drive all behaviors, we will need to track carefully how that will show up in the new proposal. The outcome is likely to shape up the evolution of equity market data distribution in the US for the next decade.
* Includes Cboe BYX Exchange, Inc. (“BYX”), Cboe BZX Exchange, Inc. (“BZX”), Cboe EDGA Exchange, Inc., (“EDGA”), Cboe EDGX Exchange, Inc. (“EDGX”), Cboe Exchange, Inc. (“Cboe”), Investors Exchange LLC (“IEX”), Long Term Stock Exchange, Inc. (“LTSE”), MEMX LLC, Nasdaq BX, Inc. (“BX”), Nasdaq ISE, LLC (“ISE”), Nasdaq PHLX LLC (“PHLX”), Nasdaq Stock Market LLC (“Nasdaq”), New York Stock Exchange LLC (“NYSE”), NYSE American LLC (“NYSE American”), NYSE Arca, Inc. (“NYSE Arca”), NYSE Chicago, Inc. (“NYSE Chicago”), NYSE National, Inc. (“NYSE National”), and Financial Industry Regulatory Authority, Inc. (“FINRA”).
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