SEC Can Avert a Great Leap Backward

Part of Arthur Levitt’s legacy as the longest-serving chairman of the Securities and Exchange Commission is a decision punted to his successor. Later this year, the commission will get to decide whether to impose old-fashioned utility regulation on a government-protected data monopoly.

At issue are the prices charged for “market data,” such as transaction prices and quotations on stocks and stock options. The New York Stock Exchange, Nasdaq Stock Market and regional exchanges report this information to four networks that consolidate it into the streams of real-time data that are purchased by brokers, the financial media, and other subscribers. Each of the four consolidation networks is the single source of price data on each stock or option. For example, all trades of GE stock in U.S. markets are reported to an entity called “Network A,” which consolidates prices for all trades of stocks listed on the New York Stock Exchange.

Congress and the SEC pressured the financial industry into establishing this system in 1975. The prices the networks charge for market data have traditionally been set through negotiations among industry participants. But 25 years into the process, the SEC decided it smelled monopoly and proposed last year to establish “cost-of-service guidelines” that networks would have to follow in setting data prices.

When this proposal stirred up a hornet’s nest, the issue got shunted off to an Advisory Committee on Market Information for further study. The committee has held two meetings and expects to finish its work in September, and then the issue will be back in the SEC’s lap.

Forcing information monopolists to sell at cost sounds attractive, but such regulation would likely harm the more than 50 percent of Americans who invest in stocks, for several reasons.

First, price regulation may be a solution in search of a problem. The SEC is mostly concerned about the market data fees that financial firms ultimately pass through to retail investors. Yet for stock market data, these fees have fallen by 50-90 percent during the past four years!

This price cut probably reflects the fact that the securities firms who control both the stock markets and the data networks make more money when transaction volumes rise. Widely-available, inexpensive price information encourages investors to do more trading, and so the networks’ owners would want to reduce data fees when the costs of producing the information fall.

Another reason that cost-of-service guidelines might hurt investors is that cost-based regulation itself tends to inflate costs. That is why regulators in the electric, telephone, gas, and other utility industries are trying to replace regulation with competition and implement alternatives to cost-based regulation where monopoly still exists.

No one has yet devised a regulatory system that cuts prices by more than half in four years without bankrupting the suppliers. Even if some monopoly pricing is occurring, cost-of-service regulation could make things worse.

A final reason that the SEC proposal may harm investors is that it ignores the root cause of the data monopoly: federal policy. During the mid-1970s, Congress and the SEC concluded that stock markets would not produce consolidated, real-time data unless it was mandated. Before the advent of IRAs and 401ks, neither federal officials nor the financial industry imagined the kind of demand for market information that exists today. Federal officials simply assumed that production of consolidated data on each security would be a monopoly.

But was this assumption correct? Policymakers also assumed that cable television, telephone service, gas pipelines, and electric service were “natural monopolies,” meaning that costs and prices would be lower if one firm served the whole market. In each case, economic research has proved the policymakers wrong, and pro-monopoly policies are now being reversed.

Government actually prevents competition in market data from emerging. The SEC sanctioned the creation of monopoly data consolidators, and new data consolidators cannot compete without regulatory approval.

The SEC also discourages individual stock markets from selling their own data in competition with the consolidated stream. A regulation called the “vendor display rule” requires that any information vendor or stock broker displaying data from some stock markets must also display the “National Best Bid or Offer” and consolidated transaction information that can only be obtained from the government-sanctioned monopoly. Buying data only from some stock markets is not an option.

Most amazing about the SEC price regulation proposal is its complete lack of historical perspective. About a century ago, most public utility commissions were offering general guidelines and principles intended to ensure that the industries they regulated could not charge prices that exceeded costs. Such guidelines were the first step into a quagmire of rulemakings and litigation that evolved into contemporary cost-of-service regulation. Experience soundly refutes the notion that regulators can achieve their intended goals merely by promulgating some guidelines.

Fortunately, some prominent members of the SEC’s advisory committee – including the New York Stock Exchange, Bridge Trading, and Archipelago ECN — have said they want to replace the monopoly data consolidator with competing consolidators. Let’s hope the commission takes their advice, learns something from the past 100 years of utility regulation, and opts for competition instead of monopoly.

This article originally appeared as guest column on Tech Central Station February 19, 2001.