Over the past year or so, I’ve been tracking the efforts of the Securities and Exchange Commission (SEC) to break what it sees as the monopolistic stranglehold of the large exchanges on the cost of US equity market data and infrastructure, and update the public data feeds known as the exclusive Securities Information Processors (Sips).

These efforts took the form of two main initiatives, rolled out mainly in 2021. One is the Market Data Infrastructure Rule (MDI Rule), which attempts to create a business environment where competing Sips could arise to offer US equity market data, leveraging their unique strengths and providing differentiated products. The other is the Consolidated Tape Plan (CT Plan), which ordered the big exchanges to draw up a plan to run the exclusive Sips that gives voting power to non-exchange market participants on the plan’s operating committee. The CT Plan further dilutes the big exchanges’ voting power on this committee by assigning votes to each exchange group rather than per medallion.

Now, from the vantage point of early April 2022, it seems all the SEC’s efforts over the past few years could come to naught. Nasdaq and the New York Stock Exchange (Nyse) have brought the MDI Rule and the CT Plan to the DC Circuit Court of Appeals. The court heard oral arguments on March 18 and 24, respectively, and industry observers say they think there could be a verdict by the summer. If the court sides with the exchanges, we could see both the SEC’s initiatives vacated.

But there’s a new threat looming for the incumbent exchanges: Lawmakers have taken notice of the SEC’s efforts and are seeking to bolster them by passing legislation.

The House Financial Services Committee’s subcommittee on investor protection, entrepreneurship, and capital markets is considering the Securities Reform Act of 2022, sponsored by subcommittee chair Brad Sherman, which would amend various bits of the Securities Exchange Act of 1934 to chip away at some of the powers that exchanges have as self-regulatory organizations (SROs).

SROs’ superpowers

The subcommittee held a hearing on the bill on March 30. Witnesses—including Ellen Greene, managing director for equity and options market structure at the Securities Industry and Financial Markets Association (Sifma); Manisha Kimmel, chief policy officer at market data fintech MayStreet; and Robert Jackson Jr., a former SEC chairman—said at the hearing that SRO powers made sense when they were granted to the big exchanges back in 1934, under the new Securities Exchange Act. In those days, exchanges were run by their broker-dealer members as non-profit utilities.

As SROs, the national stock exchanges carried out a quasi-regulatory function, enforcing their own rules and federal securities laws on their members. Along with these duties, they also had certain privileges, including liability protection. Exchange backers say these are appropriate for entities that sometimes must take unpopular actions, like halting trading to protect a fair and orderly market.

But then in the early 2000s, exchanges around the world began the process of demutualizing, in response to technological changes and a new competitive environment. Like all the other national exchanges, Nyse and Nasdaq became for-profit public companies, listed on their own exchanges, complete with shareholders and boards. A period of intense consolidation followed, so that by 2022, according to a subcommittee memorandum, 17 of the 24 US registered stock exchanges, representing an average 52% of daily equity trading activity, are owned by one of three exchange groups.

The SROs’ interests are no longer aligned with those of their own members, the witnesses said. Exchange members are now not only competing with the exchanges for order flow, they are also obligatory customers of monopolistic businesses, forced to consume market data from the very entities that produce the data and then sell it on with no apparent link between its sale price and what it costs to produce.

“In no other industry would anyone defend the government empowering one group of business (i.e., the exchanges) to surveil and regulate the business activities of its customers and competitors,” Sifma’s Greene said in her testimony. “The only thing more confounding is how long this arrangement has continued without reform.”

Sherman said the non-SROs declined to participate in the hearing, so there were no representatives from the exchanges themselves to speak on their behalf. However, a lobbyist for the industry—World Federation of Exchanges CEO Nandini Sukumar— was present.

Sukumar said in her testimony that securities exchanges play a crucial role in the markets, and work hard to ensure that their systems and infrastructure are robust and resilient, and have proved themselves both over the past few years in a period of unusual volatility. But to carry out their important functions and remain resilient, exchanges are competitive businesses, she said.

“The modern exchange has to be a dynamic and competitive business, constantly investing in new capacity in order to meet the ever-increasing demands of investors, of issuers of securities, and of financial services companies globally,” Sukumar said.

Be that as it may, Sherman’s bill looks to erode the power of exchanges to set market data fees in a couple of ways. For one, if it passes and becomes an act, it will reverse the laws that make SROs’ rules effective on filing with the SEC. As SROs, exchanges can set their own rules, including market data fee schedules. They must file them with the SEC, and if the regulator doesn’t raise any objection, the rule is effective on filing. Critics say, however, that the SROs have flooded the SEC with so many rule filings, it can’t possibly keep up to meaningfully exert its veto right.

“Exchanges seek to innovate in terms of order types, product offerings, and pricing models. In order to support those business decisions, the exchanges filed over 1,300 rules in 2021 alone. Over 700 of those were immediately effective. Compare that to over 20 years ago, when exchange filings numbered in the dozens,” MayStreet’s Kimmel told the hearing.

The bill would also stop exchanges from adopting rules that limit their own liability in the case of damages they cause.

But perhaps most interesting for anyone who has followed the fortunes of the CT Plan: If the bill becomes an act, it would amend the Securities Exchange Act of 1934 to force exchanges to include non-SRO voters on plan operating committees, explicitly in the manner laid out by the SEC’s plan.

Court challenge

The SROs have pushed against the inclusion of non-SRO representatives on the CT Plan operating committee, as mandated by the SEC’s order that forced them to create the CT Plan. These non-SRO members were chosen last year as the CT Plan order was being implemented, and are drawn from six categories of stakeholders, including institutional and retail investors, and market data vendors.

The SROs did put together the CT Plan, but they have argued that the SEC has no authority to force them to include non-SRO representatives, and that non-SROs have no statutory authority to act in connection with running a Sip. This argument formed the backbone of their oral arguments in court on March 24.

The SROs’ counsel, Thomas Hungar, a partner at Gibson, Dunn and Crutcher, said in his oral arguments then that Congress was very specific in defining the authority it gave the SEC in the Exchange Act back in 1934. “It specified who the commission can direct to act (self-regulatory organizations), how it can direct them to act (jointly), what they can act jointly about (operating the national markets system), and why SROs are the congressionally chosen recipients of this responsibility. Namely, because it involves matters as to which they share authority under the Exchange Act,” Hungar said.

Non-SROs are not mentioned because they don’t have any such authority, he added. “And just to drive home the point, Congress also specified the very different role it allocated to non-SROs. And what is that role? Advisory! … When Congress authorized the commission to direct the SROs to act jointly, it meant SROs, not anyone else with whom the commission might prefer to share the quasi-regulatory authority that Congress gave only to the SROs,” Hungar said.

It’s quite possible that the SEC will lose the court battle. This court has sided before with the SROs; most recently, in 2019, it agreed with the SROs that the SEC exceeded its authority in the transaction fee pilot.

But now with this congressional intervention, the SEC could gain back some ground. Sherman’s bill would amend the Exchange Act to say that any SRO acting jointly in operating a Sip must include non-SRO voting members “in the manner described” by the CT Plan. In other words, this bill would back the CT Plan with the force of law, so even if the plan itself were vacated by the court, the SEC’s intention to dilute the SROs’ voting power would remain.

As former SEC chair Jackson said in his testimony in the House on March 30, the exchanges have always fought tooth and nail to protect their bottom line. They fought the consolidated tapes when the SEC first proposed them back in the mid-1970s, they fought the transaction fee pilot, and, he said, they fought a lot of Jackson’s own reform initiatives. “History teaches that congressional intervention is often necessary to modernize equity market structure,” he says in a footnote in his written testimony.

The House bill is only in the earliest stages of the lawmaking process. But it does offer some hope to those market participants who fear that the SEC’s efforts to modernize the market data system might be voided by litigation.