Three prominent trading exchanges did not exactly show their government overseer the love this Valentine’s week. On February 14, 2019, the New York Stock Exchange (“NYSE”) filed a petition for review to the U.S. Court of Appeals for the District of Columbia Circuit against the Securities Exchange Commission (“SEC”), seeking review of a controversial transaction fee pilot program, slated to take effect in April. The Cboe and Nasdaq literally followed suit a day later, with nearly identical petitions. The petitions seek a ruling that the pilot program is unlawful under the Securities Exchange Act of 1934 and the Administrative Procedure Act and a permanent injunction barring the SEC from implementing the pilot program.

The SEC created the pilot program in December through Rule 610T of Regulation NMS (National Market Systems), in part based on concerns that the prevailing exchange fee structures were having a greater impact on market access and transparent trading activity than originally anticipated. Reg NMS was enacted in 2005 in an effort to modernize and strengthen the regulatory structure of the U.S. equity markets. The Access Rule, one of several initiatives enacted under Reg NMS, requires exchanges to ensure fair access to securities quotations for market participants, and established limits on the fees investors can be charged for access to the exchange.

According to the SEC’s March 26, 2018 press release announcing the proposed pilot program (83 Fed. Reg. 13008), the predominant pricing models for equities exchanges are the “maker-taker” fee model, and its inverse, the “taker-maker” model. Rule 610T establishes a transaction fee pilot program in order to analyze the effects of these fee and rebate pricing models “on order routing behavior, execution quality, and market quality generally.”

Under the maker-taker pricing model,

a trading center pays its broker-dealer participants a per share rebate to provide (i.e., “make”) liquidity in securities and, on the other hand, the trading center assesses them a fee to remove (i.e., “take”) liquidity. The trading center earns as revenue the difference between the fee paid by the “taker” of liquidity and the rebate paid to the provider or “maker” of liquidity. In a variation on this theme, some other trading centers have adopted a “taker-maker” pricing model (also called an inverted model), in which they charge the provider of liquidity and pay a rebate to the taker of liquidity.[i]

Under current rules, the fees exchanges may charge are capped at $0.0030 per traded share. While there is no cap on the amount an exchange can offer as a rebate, rebate amounts range from $0.0002 to $0.0045 per share.

The SEC identified a number of concerns regarding this fee structure, including that it may create conflicts of interest for broker dealers between best execution obligations to their customers and conflicting economic incentives to avoid fees or earn rebates, undermine market transparency (since the prices displayed on the exchange do not account for transaction fees or rebates), introduce unnecessary market complexity (through new exchanges and order types designed solely to take advantage of pricing models), and/or divert orders off-exchange to so-called dark pools. The SEC has suggested that the pilot may drive more orders onto the public exchanges and away from dark-pools. The argument is straightforward – if the fees charged to access an exchange are reduced or eliminated, then more investors will list on the exchange.

Under the pilot, selected securities will be divided into two test groups with restrictions on the transaction fees and rebates that the exchanges may charge or offer to their broker-dealer members. One test group of 730 stocks will prohibit rebates for removing and providing liquidity on an exchange, but permit a $0.0030 fee cap. The second test group, also 730 stocks, will permit rebates but will be subject to a fee cap of $0.0010 per share for the display of or execution against the stock. The pilot securities are NMS stocks (i.e., listed securities) with average daily trading volumes over 30,000 shares and a share price of at least $2.00. All exchanges are subject to the pilot – meaning that if one of the subject securities is listed on the exchange, the exchange will be required to limit its fees or rebates for that security, as directed by the pilot. Alternative Trading Systems (“ATS”), however, are exempted from the pilot.

The exchanges lodged objections to the pilot program shortly after it was announced. They argued investors must be induced to transact on the exchanges through rebates because they are forgoing the “valuable options” offered by off-exchange ATS, including “the power to decide the time of the trade and the ability to conceal trading intentions until the point of execution.”[ii] In a joint letter, the exchanges argued that the current maker-taker and taker-maker models prevent trading activity from moving off-exchange, and that restrictions on transaction fees and rebates would have the effect of diverting activity off-exchange rather than driving it onto the exchanges. According to the joint letter, the restrictions being tested in the pilot would “merely favor the intermediaries whose fees would be reduced at the expense of issuers, investors, liquidity providers, and exchanges.”

As set forth in the petitions filed by the NYSE and Cboe, the Transaction Fee Pilot “is arbitrary and capricious and otherwise not in accordance with law; does not promote efficiency, competition, and capital formation; and exceeds the Commission’s authority.” In a February 14, 2019 op-ed in the Wall Street Journal, NYSE President Stacey Cunningham, explained that the Exchange took the unusual step of suing the SEC because “the new rule amounts to an unnecessary exercise in government price-setting that will add a new layer of complexity to equity markets.” Cunningham noted that “about 40% of the market is now traded on dark venues,” and reiterated the NYSE’s original objection that the pilot will further reduce publicly displayed liquidity because intermediaries and investors will no longer have the rebates as an incentive to “show their hand” by displaying quotes publicly and thereby making a market in that security.

If it is not enjoined, the pilot will become effective on April 22, 2019 and run through December 29, 2023. After that, time – and the data collected from the pilot – will tell whether the benefit of being able to trade privately in a dark venue will outweigh the benefit of reduced or no-cost access to public exchanges.