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The U.S. Securities and Exchange Commission is investigating whether the multi-tiered pricing system used by stock exchanges favors large brokers at the expense of small ones, according to a person familiar with the matter.

Under the current system, Wall Street banks and other massive traders get hefty rebates based on how much business they funnel to exchanges. The result of this complex and often opaque system is that big users can end up trading for free, or even get paid to trade, while small brokers pay substantial fees.

Most exchange operators, including New York Stock Exchange-owner Intercontinental Exchange Inc, Nasdaq Inc and Cboe Global Markets, have embraced the system in at least some of their exchanges to help boost volumes and fatten their bottom lines.

While the SEC has not launched a formal civil investigation, it is seeking information from the exchanges on the pricing system. If the SEC were to determine that the tiered structure is unfair, exchanges could be forced to simplify their pricing models, potentially costing them millions of dollars in fees.

SEC spokeswoman Judith Burns declined to comment. NYSE and Nasdaq declined to comment on the SEC probe into multi-tiered pricing.

Cboe said it offers different types of pricing tiers catering to all of its clients and that the tiers are the result of years of intense competition among exchanges.

“At this point, we do not have plans to change our pricing schedules,” said Bryan Harkins, who co-heads Cboe’s markets division.

More generally, exchanges say that fierce competition in the industry has resulted in tighter bid-ask spreads that benefit all investors.

The regulatory scrutiny is part of a broader effort by the SEC under Chairman Jay Clayton to improve transparency around exchange pricing and ensure it is fair and equitable as required under the Exchange Act.

“The SEC has thrown the gauntlet down,” said Chester Spratt, a finance professor at Carnegie Mellon University and a former chief economist at SEC. Tiered pricing will likely emerge as a central issue in the debate, said Spratt, who has a working paper on the topic.

The regulator has also ordered exchanges to justify recent fee hikes for market data, and has mandated a pilot program to test banning rebate payments that exchanges make to brokers for liquidity-adding stock orders.

ICE, Nasdaq and Cboe have filed lawsuits or appeals challenging the SEC’s authority on those two mandates.

Tackling U.S. exchanges is one of the few areas where Republicans and Democrats agree. Republicans believe the current rules are anti-competitive, while Democrats worry existing exchange structures and incentives could hurt small and large investors.


Tensions between Wall Street and the exchanges, which were once member-owned, not-for-profit utilities, have risen over the past decade and a half as the bourses have become public companies.

Some brokers say the exchanges have used their essential position in the market to maximize profits, often to the detriment of smaller brokers.

Joe Wald, head of brokerage Clearpool Group, said tiered pricing makes it harder for smaller brokers to compete for customer orders against bigger firms, which get significant discounts on trading costs.

“It discriminates against smaller broker dealers who end up almost perversely subsidizing the cost of the whole exchange relationship for the largest firms,” he said.

Clearpool executes more than 2 percent of U.S. stock trades on an average day, but comes nowhere near hitting the higher-volume exchange tiers, which allow the biggest brokers to reap rebates nearly 60 percent higher than those that qualify for base rates, Wald said.

When factoring in rebate payments from the exchanges, five of the top 10 customers at both Nasdaq and Cboe by volume actually receive checks from the exchanges at the end of the month, net of fees, according recent comments by a Cboe executive and a Nasdaq report.


The current fee schedule was approved by the SEC, and exchange pricing lists are publicly available. But they can be dozens of pages long and it is impossible to know which brokers qualify for which tiers.

An analysis by RBC Capital Markets in October found at least 1,023 “pricing paths” across exchanges, made up of 3,762 variables, meaning that there are dozens of possible net prices for execution.

“These 3,762 variables strongly suggest that exchange prices are tailored and offered on a bespoke basis,” the report said.

Exchanges have credited pricing tiers for helping boost revenues. Bats, an exchange operator that has since been sold to Cboe, said the introduction of tiered pricing for its markets in July 2011 helped increase revenues by $14.6 million over the rest of that year.

Large brokers, which include investment banks and high-frequency trading firms, can also profit from tiered pricing by offering smaller brokers that funnel their orders through them a portion of their steeper discounts, while keeping the remainder.

Cboe’s Harkins said that this “sponsored access” allows smaller firms to share in the savings with big brokers.

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