The Securities and Exchange Commission

[thepennyking]

SEC Market Proposal Not Just for NYSE
Britt Erica Tunick
March 1, 2004

As late last week Wall Street eagerly awaited the specifics of the
Securities and Exchange Commission's proposal to alter several aspects of
the U.S. equity markets, the focus was on expected changes in the
long-controversial trade-through rule, which currently allows specialists
more time to find the best price for a stock order.

Altering the trade-through rule could hurt the New York Stock Exchange's
specialist system. But there are other equally significant issues to be
ironed out that could negatively affect some ECNs, rebate traders and
regional exchanges.

For one, the SEC is expected to propose a $0.001 cap on the access fees
currently charged by ECNs and exchanges-a change that industry observers say
will effectively eliminate access fees. While the SEC thinks that change
would make it more appealing for investors to trade in multiple locations,
ECNs have long relied on these fees to pay for order flow to be directed to
their books. Thus, the change could augur further consolidation in the ECN
arena.

"For the fringe ECNs that were out there charging up to a penny a share,
once they're told they can only charge a tenth of a cent, I don't know what
they'll do, and I think they're done," said Steve Swanson, chief executive
of Automated Trading Desk. "This basically spells the end of the game for
them." But the change is likely to have little impact on the larger ECNs, he
said.

Rebate traders are another group Swanson predicts will be hard hit by the
proposed change, labeled Regulation NMS. Rebate traders profit solely from
market data rebates-the money generated from printing trades to the tape.

"There are firms that specialize in rebate trading and aren't trying to earn
money in the spread, but are just trying to trade to earn the rebate," said
Swanson. He added that there are also a number of large retail firms that
split their market and limit orders so they can direct the latter to ECNs
for the $0.02 they are paid for that flow. "In the future, when there's
little to no rebate, they're going to be trying to figure something new to
do with those limit orders," he said. "And that is certainly a category of
firm where economics will change."

Similarly, the SEC will propose a new methodology for determining market
data rebates in a manner that more accurately rewards a firm's contribution
to the trading process. Although little is known about the specifics of the
new calculation methods, the move is essentially thought to be the SEC's
effort to stop exchanges from using rebates as the primary means of enticing
people to print their trades with them. Instead of rewarding fees based on
the number of trades an exchange or ECN generates, the new method will
reward those who provide price discovery (i.e., original bids and offers).

Now a 100-share trade in NYSE-listed stocks generates the same fees as does a trade for a million shares, whether or not the exchange or ECN handling the trade provides any quotes or has any impact on market data. Changing this process would put distribution of market data fees for NYSE stocks more in line with the process used in the OTC market. There, market data fees are rewarded based on a combination of both the share size and number of trades done.

Regional exchanges are expected to feel the brunt of this change. In
particular, industry observers pointed to the Cincinnati Stock Exchange,
which has generated sizable tape revenues by sharing them with ECNs, such as
Instinet and Island, as a means of persuading them to report their trades
there instead of with Nasdaq.

"The Cincinnati Stock Exchange just prints a bunch of shares but doesn't
necessarily act in the price discovery, because the ECNs are doing that,"
said one analyst who tracks the exchanges. "But more of the price discovery
is actually taking place on Nasdaq or Archipelago, so now they can actually
get a larger piece of the overall pie."

But with the new calculation method rumored to be so complicated that it is
jokingly said to involve a square root, the exchanges were nervously
awaiting specifics, uncertain of exactly what the changes would mean for
them. In the case of the Chicago Stock Exchange, which generates significant
order flow and quotes alike, optimism was still the name of the game late
last week.

"People are going to have to have accessible quotes in order to get their
fair share of market data revenue, and you can't have a model that simply
relies on matching other people's quotations," said David Herron, CEO of the
Chicago Stock Exchange.

A requirement for accessible quotes would likely bring a change to many of
the so-called upstairs firms (where brokerage traders can trade an
exchange's listed stocks off its floor). Upstairs firms now take their
orders and internally match them with the national best bid or offer,
without ever exposing them to the market. These firms then generate market
data revenues by reporting the trades to Nasdaq or alterative reporting
venues.

"These are orders being generated out of Chicago, the NYSE or Archipelago,
and somebody else is just matching that price and printing it elsewhere,"
said Herron. "So perhaps you shouldn't get tape revenue when you do that.