On the morning of Sept. 12, executives of the nation’s major stock and options exchanges traveled to Washington to meet with Securities and Exchange Commission Chairman Mary Jo White. The summons was prompted by a rash of technical glitches on the exchanges, the most glaring of which hit on Aug. 22, when a software failure forced the Nasdaq (NDAQ) to halt trading for three hours. White told the executives to come back in two months with a “comprehensive action plan” for making the markets more resilient. “Our homework assignments are clear,” NYSE Euronext (NYX) Chief Executive Officer Duncan Niederauer said to reporters afterward. “They require collaboration, and we’ve got 60 days.” Four days later, a glitch at an NYSE subsidiary helped bring the entire U.S. options market to a halt for 20 minutes.
Over the past decade, exchanges in the U.S. have evolved from physical places where trading is conducted by humans into vast electronic networks where computers buy and sell stocks in milliseconds. Despite—or because of—this complexity, one glitch can crash the entire system. This weakness was most apparent with the Nasdaq outage. The failure occurred in a piece of software called a securities information processor, or SIP, which is responsible for distributing stock price data to brokers, traders, and media outlets. The SIP is what feeds the tickers crawling along the bottom of the screen on CNBC (CMCSA) or Bloomberg TV, and on financial websites. When that failed, exchange officials decided to shut down all trading so that investors who still had access to price data couldn’t exploit the situation.
The system for conveying trading information dates to regulations put in place almost 40 years ago. Brokers and money managers contend that this basic pricing function, the backbone of the market, has not kept up with technological advancements that have spread across the exchanges, resulting in a two-tier system where most investors get inferior information. “Everyone will tell you the SIP is fair,” says R. Cromwell Coulson, president and CEO of the OTC Markets Group (OTCM), which operates a trading venue for 10,000 stocks that aren’t listed on NYSE or Nasdaq. “But the SIP isn’t fair.”
In 1975, the SEC forced the exchanges—the New York Stock Exchange, the American Stock Exchange, Nasdaq, and a handful of regional exchanges—to combine their trading data and publish the latest prices at which stocks changed hands on one central data feed accessible to brokers and investors. The idea was to level the playing field so all market participants could see the best prices for every stock, no matter where it was listed.
NYSE merged with Euronext in 2007, then bought Amex a year later. Nasdaq bought the Boston and Philadelphia stock exchanges in 2007, then purchased the Nordic stock exchange group OMX in early 2008. Both are now public companies that face investor pressure to boost revenue and earnings. As trading has become more automated they have lost share to new electronic exchanges such as BATS and Direct Edge. Even so, the SIP operated by Nasdaq and NYSE remains responsible for disseminating market data to the public.
The SEC allows the exchanges to charge brokers, money managers, and media a fee for the information. That money is split among all the exchanges based roughly on their market share of total trading volume. Over the years, the public data had been a lucrative source of revenue. They generated $463.9 million in 2008, according to the SEC. After deducting $14.8 million for expenses associated with collecting the data, the exchanges divvied up $449.1 million. As trading volumes have diminished over the last five years, though, so has the revenue. According to data compiled by financial market consultant Tabb Group, public data revenue fell to $445 million in 2012 and is expected to come in at about $430 million in 2013.
NYSE and Nasdaq have helped offset the decline in public data revenue by selling proprietary data feeds to a variety of market participants, including high-frequency traders. These feeds arrive sooner and contain more information than the SIP—including all prices being offered, not just the best ones. By law, prices must be entered into the public and proprietary feeds at the same time, but the proprietary systems process and transmit the information more quickly. From 2006 to 2012, Nasdaq’s proprietary market data revenue more than doubled, to $150 million from $69.6 million, while its public data revenue fell to $117 million last year from $149 million in 2007.
Some market participants suggest there is a clear conflict of interest that has led Nasdaq and NYSE to neglect the public feed, making it more susceptible to breakdowns. “There is no question they have underinvested” in the SIP, says Jeffrey Brown, a senior vice president at Charles Schwab (SCHW). As a discount brokerage, Brown says, Schwab can’t afford to buy the proprietary feeds for all its clients, which puts them at a disadvantage. The system is “flawed and degrades the data we can provide to our clients,” he says.
Brokers should have a choice of market data providers operating multiple versions of the SIP, says OTC Markets’ Coulson. Not only would that add some redundancy to the system, it would give independent companies an incentive to make the public feed as fast and efficient as possible. “There is zero competition or choice,” he says. “What kind of information provider doesn’t change their data? Doesn’t make it deeper? Doesn’t improve the quality every year?”
Nasdaq and NYSE maintain that they’ve invested adequately in the public feed. While the system has been made faster over the past few years, both exchanges admit that the public data feed is still slower than proprietary ones. The amount that Nasdaq and NYSE must spend to maintain the public feed is determined by a committee comprised of executives from the exchanges and from the brokerage industry’s self-regulator, the Financial Industry Regulatory Authority. Neither the committee nor Finra would comment.
The issue of public vs. private data is shaping up to be a core part of White’s effort to make the exchanges more resilient. Even before the Nasdaq outage, the SEC introduced a proposed rule that would require exchanges to adopt policies to prevent failures, stress-test their systems, and report disruptions to the SEC. The proposal, Regulation SCI, would replace a voluntary program created after the crash of 1987 and expand the SEC’s oversight. “White needs to be convinced these guys, all of them, take this with the utmost seriousness,” says Andrew Klein, a former director of trading and markets at the SEC and now a partner at New York-based law firm Schiff Hardin. “It’s starting to look like Nasdaq can’t stop these problems, and they need to stop.”