NSX Seeks to Enter the ETF Fray, Take Business from the NYSE, NASDAQ

By Lawrence Carrel

Standing high above Exchange Place, Joseph Rizzello looks out the windows of his trading floor across the Hudson River to Lower Manhattan. In May, the chief executive officer of the National Stock Exchange [NSX] brought its electronic trading platform from the Midwest to Jersey City, N.J., to take on the big boys of Wall Street. His goal? To fill the competitive void left behind by the New York Stock Exchange's acquisition of the American Stock Exchange.

In February, the NSX introduced an aggressive but simple fee schedule intended to steal trading volume, especially in exchange-traded funds, from the NYSE (NYX) Arca platform and the NASDAQ Stock Market (NDAQ). It instituted an inverted pricing structure across all securities. Stock exchanges earn revenue by charging fees on trading volume. But the NSX is taking a loss on every trade to bring in traders. For securities trading on Tape A (those listed on the NYSE) and Tape C (for NASDAQ issues), the "liquidity provider" - or the firm instigating the trade - gets a rebate. The NSX pays the provider 26 cents per 100 shares for bringing the trade to the exchange. The firm taking the other side of the trade, i.e., the "liquidity remover," is charged 25 cents per 100 shares to take securities off the exchange. On every 100-share lot traded, the exchange loses a penny.

For ETFs, the spread is even wider. On Tape B (the trading tier for NYSE Arca and Amex securities), the liquidity provider receives 30 cents per 100 shares for choosing to trade on the NSX. The liquidity remover gets charged the same 25 cents, leaving the stock exchange down 5 cents for every 100 shares traded.

Compare that with the NASDAQ Stock Market and the NYSE Arca. The majority of the volume on the NASDAQ receives a 28-cent rebate to bring liquidity and a 29-cent charge to take it. That's probably why the NASDAQ held 30.4% of the total U.S. equity volume in June, more than any other U.S. exchange for the fifteenth month running---because for each 100 shares traded, it charges only a penny profit. Nasdaq's average daily volume for all U.S. securities was 2.5 billion shares, up 43% from June 2007.

June's average daily volume of U.S. ETFs rocketed 99% year-over-year to 477 million shares, also more than any other exchange. Market share climbed to 37.9% from 35.7% in May. (LC 7/9) Meanwhile, if you want to trade on the NYSE Arca, unless you trade 90 million shares a month, you're going to have to pay for it.

On July 1, the NYSE Arca changed its rates. Now, the rebate for adding liquidity for ETFs ranges from 22 cents to 23 cents per 100 shares depending upon average daily volume per month. The fee to remove liquidity ranges from 28 cents to 30 cents per 100 shares.

Average daily volume at NYSE Arca surged 79% to 881.7 million shares in May, before the new rates were in place; it remains to be seen what impact the rate change will have this summer.

While the playing field hasn't shifted yet, traders are beginning to take advantage of the NSX's generosity. The NSX holds about 2% of the market share in the ETF market, says Michael Traynor, NSX's chief strategy officer. That a 300% increase from half a percent at the end of 2007. At the end of June, it traded 30 million shares a day, up from 5 million at the end of the year.

So, how does the NSX make money? Through the sale of market data.

"When you factor in all the market data [that traders pay for], it costs about 3 cents per 100 shares to do business with us, and that is less than anyone else," says Rizzello. "The other exchanges are about 12 cents per 100, four times larger." The exchange doesn't report revenues, but Rizzello says it's operating at breakeven, and he expects it to be profitable by the end of the year.

"Firms that trade 20 million shares in ETFs over the course of the year would save $3.8 million in exchange fees if they trade on the NSX versus the NASDAQ," says Traynor.

The NSX isn't just some Johnny-come-lately to the exchange business. It's 123 years old. Founded in 1885 as the Cincinnati Stock Exchange, NSX eliminated its physical trading floor in 1980 and became an all-electronic stock exchange. The Cincinnati exchange moved to Chicago in 1995, and became the National Stock Exchange in 2003. Originally a non-profit corporation, it's now a for-profit company. Its investors include Merrill Lynch, Credit Suisse, Citigroup, JPMorgan Chase, Knight Capital Group and Bloomberg. The new $10 million trading platform went live in January 2007.

Rizzello isn't just some guy jumping on the ETF bandwagon, either. He was on the Philadelphia Stock Exchange team that created the Cash Index Participation shares [CIPs]--a precursor to the ETF. This first exchange-traded ancestor to the ETF lived only three months in 1989, four years before the launch of the Spider. Rizzello later moved to Vanguard to help create the Vipers, the original brand name for Vanguard's ETFs.

But there are dark clouds entering Rizzello's view over the Hudson. The NSX could potentially lose its two biggest clients, or half its business, over the next 12 months. BATS Trading, the third-largest U.S. equity market, and Direct Edge, another trading venue, are expected to become licensed stock exchanges this year. Regulations have required the two firms to quote their trades through a licensed exchange; in this case, the NSX. But once they become full exchanges, they can quote their own trades.

The NSX plans to generate business from the traders locked out of the discounts given to the big clients of the NASDAQ and NYSE Arca. Such traders include mid-level broker-dealers, private high-frequency trading shops, specialists and market-makers.

"We always knew and understood that they would seek an exchange status," says Rizzello. "It's not a surprise. We planned for it and that's why we implemented the new pricing schedule. We expect that by the time they leave, we will have replaced the bulk of that order flow. We know it's not an easy process, and no doubt, it's a big challenge. But I'm happy with the success so far and believe we'll be successful at the end of the day."

Does NSX have the size and scope to compete with the better-capitalized firms in the business? Time will tell. But for now, with their aggressive rebates and discounts, they're making a serious run at it in the ETF arena.

 

Comments

[Jmar11]

Very interesting article. I wonder if this will begin a wallstreet pricing war? The walmart of wall street perhaps.
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