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.

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