'They are pulling things out of thin air:' The war tearing apart Wall Street has reached a fever pitch

Thomson Reuters

Traders work on the floor of the NYSE in New York

• Infighting between Wall Street firms over a proposal to shake up trading has reached a fever pitch.
• The benefits of rebates, incentives for traders to make markets on exchanges, have long been argued.
• Now, some exchanges are taking an aggressive stance against a proposal by the SEC that would eliminate rebates in certain cases.

A proposal to shake up stock trading in the US has been tearing apart Wall Street, and now the infighting has reached a fever pitch.

The Securities and Exchange Commission in March proposed a pilot program that would the impact of examine rebates, a type of incentive some stock exchanges pay out to traders to lure them to their venues. The pilot would eliminate rebates in certain cases in order to analyze how the practice impacts the markets.

Legacy stock exchanges, including the New York Stock Exchange and Nasdaq, are up in arms over the proposal, with NYSE saying in a letter to the SEC last week that it would put venues like theirs in economic jeopardy. On the other side of the fight are pension funds and upstart exchange IEX, which argue the pilot will provide regulators with the necessary information to make a judgment on rebates.

"They are pulling things out of the air," John Ramsay, chief market policy officer at IEX, said in an interview with Business Insider, referring to his exchange rivals. "They say 'this is going to really hurt investors,' but all the investors are coming out to say this is something we really want."

Notably, a group of pension funds - including the California Public Employee's Retirement System - came together to support the pilot, arguing that rebates create conflicts of interests between brokers and investors. IEX has long said rebates are harmful, forcing traders to route orders to venues where exchanges will pay them the most, not where they will be best executed.

Nasdaq and NYSE have harshly criticized the pilot in comment letters, with Nasdaq saying it is "arbitrary and capricious and would not withstand judicial scrutiny."

Cboe, the options and derivatives exchange based in Chicago, was equally blunt: "The Proposal is Severely Flawed."

Countered IEX's Ramsay: "Remember we are talking about a pilot. They're are obviously so threatened by the idea and what the results might show."

To be sure, IEX has a different model of incentivizing clients to trade on its platform, and the pilot's implementation could be viewed as a stamp of approval of its model.

Costly for mom-and-pop investors?

In NYSE's letter, the exchange operator said the two-year pilot would drive trading to off-exchange venues, such as alternative trading systems operated by UBS and Credit Suisse, which don't have to participate in the pilot. Trading on such venues is less transparent and less regulated, NYSE said.

Primarily, however, exchanges are concerned that wider spreads will result from market makers not having economic incentive to quote the narrowest spreads. The cost of wider spreads will fall upon retail investors, according to NYSE, and those costs could be as high as $4 billion.

Cboe estimated the pilot would translate into wider spreads across 3,000 securities which could add an additional $400 million in execution costs for mom-and-pop investors.

Other market participants have questioned the accuracy of those figures.

NYSE's figures are "absolutely a misunderstanding of how the markets work and either reflects intellectually dishonesty or silliness," said Ronan Ryan, IEX's president, in an interview.

NYSE declined to comment further on questions about the accuracy of its estimates.

The pilot, which could take years to go into effect, would require exchanges to run three test groups or "buckets." Each bucket will have fees that are lower than the current rates. One bucket will be a group that will allow exchanges to charge fees at current levels and another bucket will not allow rebates.