It's getting hard to keep up with the changes in fee structures emanating from U.S. stock exchanges and ECNs. Equity market players are changing their transaction prices left and right, offering higher rebates to liquidity providers or lower take-fees to those firms that remove liquidity.

On April 29, Direct Edge announced a new fee schedule for its two platforms, EdgeX and EdgeA. That came the day after Nasdaq announced a new, unified pricing structure for NYSE-, AMEX- and Nasdaq-listed securities. A week earlier, on April 23, ISE Stock Exchange changed its fees. All of this is on the heels of rebate increases at NYSE Arca, which triggered an e-mail from BATS Trading CEO Joe Ratterman to market participants and observers criticizing NYSE Arca's new fee schedule.

"They're obviously trying to outdo each other," observes Sang Lee, managing partner at Aite Group, who explains that the goal is to get traders to alter their order routing systems to reflect the fee changes at the execution venues. "If you become more aggressive, you should be able to get a bump in your market share," he adds. "The problem is, if everyone is doing it within two weeks, is this useful or is this an exercise in futility?"

A lot of this is geared to attracting the high-volume players, Lee continues, noting that high-frequency trading firms have helped BATS ECN and Direct Edge, in particular, grow their market share. "[Now] some of the other established exchanges are trying to get in to that game," he comments.

BATS Trading started the trend with an inverted pricing promotion in January 2007 to capture more volume in Nasdaq-listed stocks. BATS offered a rebate of $0.003 for adding liquidity and reduced its fee for taking liquidity to $0.002. BATS did the same thing again in September 2007, offering a rebate of $0.0034 and a take-fee of $0.0024 for NYSE-listed securities. In each case, after a month, BATS reverted to its normal pricing ($0.0024 to add and $0.0025 to remove liquidity).

Emulating that strategy, exchanges -- including NYSE Arca and Nasdaq Stock Market -- have increased their rebates to attract the black-box trading firms and algorithmic trading shops that execute tens of millions of shares per month. Recent pricing changes at NYSE Arca and Nasdaq (pending filing with the SEC) are aimed at firms that execute average daily volumes in excess of 30 million shares per month.

But while these rebates are meant to lure the high-volume players, there are some drawbacks. In addition, one must read the fine print to figure out if there are volume limits to the higher rebates and how this affects other customers that can't meet these high-volume tiers.

"It's like airline miles," says Lee. "Yes, you can get an upgrade. But if you read the fine print, it's only during certain days."

Still, Lee adds, the price changes are a natural reflection of the markets. "[Equity markets] have to be very aggressive in their pricing schedules. ... The U.S. equities business is a commoditized business, and the only way to survive is to do this," he explains. "Just imagine if they didn't do anything." Lee notes that the NYSE has lost market share even after implementing price changes.

But if the top equity exchanges and ECNs continue to offer higher rebates and lower take-fees, how will their economics change in the long run? "It's very tough to be competitive in a market where the profit margin decreases and the competition continues to increase and there is a tremendous amount of pressure on pricing," says Lee.

Is There an End in Sight?

So can the exchanges sustain the rebate game? The larger, global and more diversified exchanges can sustain the strategy, according to Lee. But ECNs such as BATS and Direct Edge are more vulnerable since they depend on U.S. equity transaction fees as their main source of revenue, he points out. However, BATS and DirectEdge both are applying for exchange licenses, so they will have the ability to earn revenues from other sources, such as listings and market data.

But for how long can this go on? Lee says he wouldn't be surprised if the larger equity exchanges started allowing firms to trade for free.

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