Exchanges and a few high-frequency traders are under scrutiny for a rebate pricing system regulators believe can distort pricing and diminish liquidity and cost long-term investors.

So-called maker-taker fees offer a transaction rebate to those who provide liquidity (the market maker), while charging customers who take that liquidity. The chief aim of maker-taker fees is to stimulate trading activity within an exchange by extending to firms the incentive to post orders, in theory facilitating trading.

Makers typically are high-frequency trading firms, whose business models largely depend on specialized trading strategies that are designed to capture payments. "Takers" are typically either large investment firms looking to buy or sell big blocks of stocks, or hedge funds making bets on short-term price moves.

The maker-taker model runs counter to the traditional “customer priority” design, under which customer accounts are given order priority without having to pay exchange transaction fees. Under the customer priority model, exchanges charge market-makers fees for transactions and collect payments for order flow. Order flow payments are then funneled to brokerage firms in an effort to attract orders to a given exchange.

An Added Incentive

The maker-taker plan harks back to 1997, when Island Electronic Communications Network creator Joshua Levine designed a pricing model aimed to give providers an incentive to trade in markets with narrow spreads. Under this scenario, makers would receive a $0.002/share rebate and takers would pay a $0.003/share fee, and the exchange would keep the $0.001/share difference. By the mid-2000s, rebate capture strategies had emerged as a staple of market incentive features, with payments ranging from 20 to 30 cents for every 100 shares traded.

Exchanges employing maker-taker pricing programs include the NYSE Euronext’s Arca Options platform and the NASDAQ OMX Group Inc.’s (Nasdaq:NSDQ) NOM platform, as well as the new U.S. options exchange launched by BATS Global Markets. The International Securities Exchange Holdings, Inc. and The Chicago Board Options Exchange, owned by CBOE Holdings, Inc. (Nasdaq:CBOE) both use the customer priority system.

Possible Pricing Distortions

Detractors of the practice believe that publicly-viewed bid/offer prices in the market are rendered inaccurate by the rebates and other discounts. Some opponents note that high-frequency traders exploit rebates by buying and selling shares at the same price to profit from the spread between rebates which masks the true price discovery of assets. Others maintain that maker-taker payments create false liquidity by attracting people only interested in the rebates and who do not actually substantially trade shares.

Studies by University of Notre Dame finance Professors Shane Corwin and Robert Battalio and by Indiana University Professor Robert Jennings both found that stockbrokers regularly channeled client orders to markets that provide the best payments, which yielded worse results than if the brokers hadn’t considered the payments.

A Closer Look

In January 2014, Jeffrey Sprecher, CEO of IntercontinentalExchange Group, Inc. (NYSE:ICE) which owns the New York Stock Exchange, called for regulators like the Financial Industry Regulatory Authority and the Securities and Exchange Commission to look deeper into rebate pricing practices. And in a letter to the SEC, The Royal Bank of Canada’s (NYSE:RY) Capital Markets Group claimed that maker-taker arrangements fostered conflicts of interest and should possibly be banned. Following the outcry, Senator Charles Schumer (D.-N.Y.) requested that the SEC study the issue, and in an April 2, 2014 speech, SEC commissioner Luis Aguilar announced the SEC is contemplating a test initiative to curtail maker-taker rebates via a pilot program that would jettison maker-taker fees in a select group of stocks for a probationary period to demonstrate how trading in those securities compares with commensurate stocks that retain the maker-taker payment system.

The Bottom Line

While maker-taker fee systems have seen an uptick in usage since their late 1990s inception, their future remains uncertain, as academics, financial institutions and politicians have called for regulatory scrutiny of the pricing model. An impending pilot initiative to investigate further could lead to significant changes in the practice.

Related Articles
  1. Investing News

    Has High Frequency Trading Ruined The Stock Market For The Rest Of Us?

    HFT is a controversial trading strategy. This article looks at how HFT affects the retail investor.
  2. Brokers

    ECN Credits: Let Your Broker Pay Your Trading Fees

    Altering your entry and exit strategy could save you a lot of money in fees. Find out how to pad your bottom line.
  3. Investing

    The Three Most Notorious Rogue Traders

    The conviction of former Barclays trader Tom Hayes has once again shone the spotlight on rogue traders. Here are three of them.
  4. Technical Indicators

    Basics Of Algorithmic Trading

    Algorithmic trading is the process of using computers for placing trades in order to generate profits at a speed and frequency that are beyond a person’s capability.
  5. Trading Systems & Software

    The Perfect Moving Averages For Day Trading (AAPL)

    5-, 8- and 13-bar simple moving averages offer perfect inputs for day traders seeking quick profits on the long and short sides.
  6. Trading Strategies

    Basics of Algorithmic Trading: Concepts and Examples

    Algorithmic trading makes use of computers to trade on a set of predetermined instructions to generate profits more efficiently than human traders.
  7. Investing Basics

    The Top 25 Broker-Dealer Firms in 2015

    The country's largest broker-dealer firms by annual revenue are clearly doing lots of things right, but they're also facing a massively shifting market.
  8. Brokers

    Duck These Illegal Sales Tactics Used By Brokers

    Many unscrupulous brokers employ illegal swindling tactics to sell bad securities. Here are sales strategies that should indicate red flags to investors.
  9. Your Practice

    How Brokers Are Compensated for Selling Bonds

    Find out how brokers are paid for selling bonds and how the transaction costs are passed on to the investor through a markup or commission.
  10. Investing Basics

    How To Outperform Warren Buffett Using Market Simulators (BABA, MSFT)

    That moment when you realize you just booked $108 million dollars in less than an hour: it puts butterflies in your stomach.
RELATED FAQS
  1. Does OptionsHouse have mutual funds?

    OptionsHouse has access to some mutual funds, but it depends on the fund in which the investor is looking to buy shares. ... Read Full Answer >>
  2. Are hedge funds on the buy side or the sell side?

    Hedge funds are considered to be on the “buy side” rather than the “sell side” because they actively participate in the markets ... Read Full Answer >>
  3. Can you invest in mutual funds on E*TRADE?

    E*TRADE allows investors to invest in thousands of mutual funds through its investment platform. E*TRADE has over 8,000 leading ... Read Full Answer >>
  4. Some of the Best No-load Funds to Consider

    Some of the most well-known no-load funds are the DoubleLine Total Return Bond Fund (DLTNX), Vanguard Short-Term Investment-Grade ... Read Full Answer >>
  5. Can you invest in mutual funds on Scottrade?

    Scottrade, Inc. offers investors a versatile selection of mutual funds in which they can invest. Scottrade allows investors ... Read Full Answer >>
  6. What action is the SEC likely to take on 12b-1 fees?

    The Securities and Exchange Commission (SEC) may take action to impose greater regulation on how 12b-1 fees are used, or ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center