June 08, 2012

Nasdaq OMX’s plan to compensate brokers for their losses in the botched Facebook IPO with discounted trading fees has provoked the ire of rival exchanges, but one analyst views this as a clever move.

“We view the proposal as a clever way to shift some of the burden to competitors by making the Nasdaq a more attractive trading venue in terms of cost,” wrote Rob Rutschow, exchanges analyst for CLSA. Rutschow points out that US cash equities revenue if just 8 percent of Nasdaq’s total revenue, and $40 million is 2 percent of Nasdaq’s total revenue base. “As a result the financial impact may not be as big,” wrote Rutschow in a report.

On Monday, Nasdaq said it would pay its members as much as $40 million for losses incurred when Facebook’s first day of trading was plagued by technical problems. Under the Nasdaq proposal, approximately $13.7 million of the pool would be paid in cash to member firms, while the balance would be credited to members to reduce trading costs, with all benefits expected to be achieved within six months for the vast majority of firms, said the company’s announcement on Monday.

However, market makers have estimated their losses to be more than $100 million, according to published reports. CSLA’s analyst wrote that losses are estimated to be $100 to $150 million and Nasdaq’s total pool set aside to accommodate brokers is around $50 million.

“While brokers aren’t going to be happy with the amount being offered, complaints by competitors suggest that the plan is clever,” Rutschow wrote in his report.

Rivals, however, don’t think the plan is so clever. Yesterday, at a conference that was supposed to discuss market structure, Nasdaq’s Facebook IPO compensation plan was the main topic of discussion. Rival market operators including Direct Edge chief executive William O’Brien delivered strong criticism of the plan to compensate brokers with discounts on futures trading costs, calling the reimbursement proposal, “illegal” and “shameless,” according to the New York Times DealBook coverage.

However, exchange operators frequently change their so-called “make-or-taker rebate policies to reward electronic market makers for adding liquidity or removing liquidity. So it’s not necessarily the case that Nasdaq’s plan is any different, though in this case, the discounts are meant to compensate firms that suffered losses on the Facebook IPO.

In his report, CLSA’s analyst notes that “NYSE Euronext has complained that Nasdaq may gain share as a result of the proposal but generally the exchanges have been able to set pricing, and in the absence of the Facebook situation, Nasdaq would be able to implement the same pricing structure without any comment from competitors.”

However, it’s not only competitors who are voicing an opinion. Chris Concannon, a former Nasdaq executive, who previously headed up transaction services for the global market operator, also weighed in on the impact of the Facebook IPO.

From New York Times DealBook:

Chris Concannon, an executive at the trading firm Virtu Financial, spread his criticism more broadly, telling the conference, which was held at the St. Regis hotel in Manhattan and sponsored by the investment bank Sandler O’Neill, that the offering “was a complete debacle on all parts.” “The I.P.O. window is gone, literally gone because of this I.P.O.,” he said.

So not only is the industry angry that Nasdaq’s compensation plan is unfair and will attract market share at their expense, they are hoisting blame on the exchange operator for killing the IPO market overall.

While the Nasdaq has become a punching bag for everyone’s Facebook frustrations, according to CLSA’s analyst, once again, anger is a sign of the plan’s cleverness. On the other hand, there is a risk that brokers like Knight Capital, which is upset with the size of the payout, could seek legal action. According to Rutschow, "Knight would need to prove gross negligence on the part of Nasdaq which would seem to be a high hurdle."

Even if the industry was able to claim losses of $200 million and Nasdaq was hit with all of the costs, the $150 million in additional liability has been reflected by market-cap reduction, the analyst estimates. Since May 17, the day before the Facebook IPO, Nasdaq’s share price has underperformed NYX’s by 4.3 percent, which would equal about $165 million in market cap, the analyst wrote. When compared to the CBOE ‘s share price, which has increased 8.3 percent since the Facebook IPO, this implies Nasdaq has underperformed by 11.6 percent or about $450 million in market cap — or triple the maximum liability legally if broker losses were trebled, according to CLSA's analyst..

Hence, the decline in Nasdaq OMX’s share price has already reflected the Facebook IPO reimbursement plan and potential law suits, but if this is true, then Nasdaq's shareholders have already paid the price, and not necessarily the exchange operator.

ABOUT THE AUTHOR
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in ...