Fee jump could dampen U.S. trading tactics, volumes

NEW YORK (Reuters) - U.S. stock exchanges and their most active traders are bracing for transaction fees to increase more than four-fold, which could affect trading strategies in a market that so far has managed to keep churning despite the severe sell-off.

There will be at least some impact on trading volumes when the fees -- levied on stock sellers by U.S. regulators -- jump next month, forcing smaller firms in particular to adjust strategies for making money in the recently volatile markets.

The fee increase is intended to avert a possible funding shortfall for the U.S. Securities and Exchange Commission, the federal watchdog that regulates stock and options trading.

The SEC needs $1.02 billion to do its job, and beginning on April 10 it will charge $25.70 per $1 million in securities sales, up from the current $5.60, for equity and option trades on exchanges and over-the-counter markets.

Especially hard-hit will be institutional, high-frequency traders, who submit hundreds of orders per day. These private firms represent about 65 percent of overall matched volume and drive the vast majority of volatility that whipsaws stocks.

With high-frequency trading firms grabbing a growing share of the market, experts say any possible drop in trading volume depends on how well these firms weather the higher fees.

“We’re talking about a significant amount of money and certainly it will impinge on the high-frequency traders’ volumes a little bit, but it is spread out across the industry,” said Joe Gawronski, president of Rosenblatt Securities, an agency broker specializing in market structure.

The SEC’s so-called Section 31 fee fluctuates regularly. The current, $5.60 fee is the lowest in a decade, while the highest fee came in 2003, at $46.80.

BIGGER WORRIES

At the moment, market operators, who derive revenue from trading volume, are relatively sanguine about the fee hike -- possibly because they have bigger worries on their plate. Of greater concern are possible new rules to curb short selling and the prospect of a transaction tax.

With the new Section 31 fees, high-frequency trading firms “may not be as aggressive as they could be, had that fee not been there, but by a de minimis amount, maybe 1 to 2 percent reduction in overall activity,” said Bill Karsh, chief operating officer at Direct Edge, the fast-growing alternative trading venue that executes 11 percent of U.S. equity trades.

Of the four main U.S. venues, which pass the fees on to customers, BATS Exchange is the most reliant on high-frequency traders while the New York Stock Exchange is the least reliant, said Rosenblatt’s Gawronski. The others are Nasdaq Stock Market and Direct Edge, which is not yet a formal stock exchange.

Robert Greifeld, chief executive of Nasdaq OMX, told reporters: “I understand where the SEC is coming from,” when asked earlier this month whether the higher fees would affect trading volumes. Big Board parent NYSE Euronext and BATS had no comment.

SMALL VOLUME DROP

After surveying several high-frequency trading firms, Rosenblatt concluded that higher Section 31 fees will dampen U.S. equity trading volumes by up to 2 percent.

The survey, published this month, also found that firms might “tweak their strategies somewhat,” perhaps by scaling back trading of the few high-priced stocks that remain.

Buying and selling high-priced shares such as Google Inc, whose stock price is now about $340.00, will bring traders to the $1 million threshold of Section 31 quicker than would depressed shares such as Citigroup, whose shares are trading at around $3. However, the badly beaten bank stocks have been the most active in recent months.

Still, the higher fee will boost costs for market makers. Goldman Sachs downgraded Knight Capital, a market maker and trading services provider, to “neutral” last week, noting higher Section 31 fees would reduce annual earnings.

While Knight will directly absorb much of the higher costs, exchanges are indirectly vulnerable only if there is a drop in trading volumes. The NYSE and Nasdaq funneled a combined $77 million in Section 31 fees to the SEC in the fourth quarter.

Equity Research Desk, an advisory firm focused on exchanges, noted annual industry “friction costs” will jump by $1.2 billion based on data from the volatile fourth quarter.

U.S. equity volumes could decline by 15 percent this year and may be even more pronounced if the current volatility, driven by overall uncertainty, settles down, said ERD analyst Bernardo Mariano.

“They put in an order when they see an opportunity,” Mariano said of the highly active traders. “But if now the costs are doubled, they’ll see less opportunity and they’ll reduce dramatically the number of orders in the market.”

UPTICK RULE

Exchanges are more concerned with the prospect that regulators will impose new rules to curb short selling, and the far more remote -- and devastating -- prospect of a new transaction tax, both of which could sharply reduce volumes.

Exchanges are working with the SEC on a possible new “uptick” rule that would limit short selling, a trading strategy that aims to profit from falling stocks. Meanwhile, U.S. Rep. Peter DeFazio’s proposal for a 0.25 percent tax on all transactions has gained little traction in Washington.

Although higher Section 31 fees are quite tolerable in comparison, “anything that increases your costs by nearly five times is going to matter to you,” said Doreen Mogavero, NYSE floor broker and president of member firm Mogavero, Lee & Co.

“It probably won’t be compelling enough for (high-frequency firms) not to trade, because at these levels, stocks are cheap and you can flip around a lot bigger positions,” she said.

“But if this market begins to flatten out and just stays there, then obviously this is going to make a difference.”