Why would reforming maker-taker venue pricing improve investor confidence in equity markets?
The pricing structure has always faced a certain amount of denigration from buy-siders who believe it doesn’t work in their favour. And now it has even gained the attention of a New York senator who has lobbied the Securities and Exchange Commission (SEC) to reform it.
Democrat Charles Schumer voiced buy-side suspicions in a letter to SEC chair Mary Shapiro last month, beseeching her to address what he sees as a “major conflict of interest in securities trading” that may be costing investors up to US$5 billion per year.
He cited a study from consultancy Woodbine Associates which said differences in exchange performance were rarely considered by smart order routers that direct trades to the multiple venues that trade US stocks.
Woodbine’s study shows maker-taker creates conflicts of interest because brokers are incentivised to execute trades on a venue even if it isn’t offering the best price. The study asserted customers have lost up to US$5 billion as a result of “sub-optimal order routing decisions”.
Woodbine principal Matt Samelson is pressing money managers to take ownership of where their orders are executed.
What’s the history of maker-taker?
The pricing structure’s origins go back to the US equities markets of the late 1990s, when electronic communications networks (ECNs) charged fees for both passive and aggressive trades (with lower fees for passive). But competition gave way first to free passive trades and eventually rebates.
The structure potentially can offer greatly reduced trading costs compared with other fee models – particularly for those posting a lot of orders on trading venues’ order books. But if – in this fragmented world – end-users can’t be sure their intermediaries know how and why and where their orders are executed, is it any wonder they are wary of their broker’s intent?
So this is simply a case of the buy-side’s natural suspicion towards the sell-side?
Not at all. A surprising number of detractors have been brokers. Back in 2010, Knight Capital had its own beef with the maker-taker model. In a study it sponsored, conducted by three leading academics, Knight found maker-taker benefits neither liquidity providers nor liquidity takers. And it distorts stock prices.
USC professor of finance and business economics Larry Harris, Georgetown associate professor James Angel and Carnegie Mellon University academic Chester Spatt argued maker-taker rebates may have had helped narrow spreads but liquidity takers were no better off because of access fees.
Harris and Spatt – both former SEC chief economists – believed while maker-taker had helped narrow quoted spreads, actual economic spreads had not changed because quoted spreads don’t incorporate access fees, meaning stock prices are distorted.
“The make-or-take pricing model thus would appear to accomplish nothing besides reducing quoted spreads and thereby obfuscating true economic spreads,” the study found.
Other critics worry about the underlying problem of high-frequency trading (HFT) firms practicing ‘rebate arbitrage’.
They reckon rebates have skewed asset prices and are responsible for countless artificial arbitrage trades, contending that rebates are used by exchanges to entice HFT clients thereby increasing the exchange’s market share.
So what’s the solution?
Senator Schumer has called on the SEC to require rebates and other incentive payments be passed on to investors and fully disclosed. He believes there shouldn’t be any incentive for traders “to profit at the expense of their investors”.
Woodbine’s Samelson reckons one avenue would be for regulators to require exchange fees were passed on to security principals, going a long way to removing this particular conflict. But he warns it may cause other market micro-structure related issues.
Some believe the structure should simply be banned altogether. Certainly such a move would be more transparent to investors, but surely all that lovely HFT liquidity would go down the drain. Of course, many might also see that as a positive…