Is the Maker-Taker Pilot DOA?
By Ivy Schmerken
After more than a decade of debate, regulators are poised to act on a pilot for maker-or-taker pricing, a practice whereby market makers are paid a rebate to add liquidity and are charged a fee to remove liquidity by electronic trading venues.
The SEC’s Equity Market Structure Advisory Committee (EMSAC) has recommended to move forward with a pilot on reducing access fees to gain an understanding into how rebates and access fees influence order routing decisions.
The SEC could open the maker-taker pilot for public comment in 2017.
But, now analysts are suggesting that a maker-taker pilot is in limbo, or at the very least, could be postponed under the incoming Trump administration.
In a Jan. 9 article, Larry Tabb, founder and research chairman of TABB Group, told Pensions & Investments that a potential maker-taker pilot could be ‘dead’ before it starts. The incoming administration would prefer to conduct a holistic review of Reg NMS market structure, Tabb told P&I. With the SEC transitioning to a new chairman under President Trump, Tabb said there is uncertainty as to what will be on the market structure agenda. Trump’s nominee to head the agency, Jay Clayton, an attorney with Sullivan Cromwell, is due to go through confirmation hearings and has not yet had a chance to air his views in public.
Paul Atkins, a former Republican SEC Commissioner, who reportedly has served as President Trump’s regulation advisor, could give Regulation NMS “a second look,” reported Reuters in “A Post- Post Trump SEC.“ Atkins has critiqued SEC rules that require “best price” execution as causing fragmentation and harming price discovery by causing orders to go away from traditional exchanges to dark pools.
But Republican Commissioner Michael Piwowar, who was named acting chairman of the SEC in January, could revisit the rules sooner than later.
Too Much Complexity?
One of the concerns is that a maker-taker pilot would add complexity to the equity market structure. The industry is already conducting the tick-size pilot for small cap stock by widening spreads to a nickel and testing a Trade-At rule, which some industry folks contend has been expensive in terms of programming and too complex to implement.
However, supporters of the maker-taker pilot are speaking up. In a blog posted to their own site, Themis Trading partners Joe Saluzzi and Sal Arnuk, maintain that a maker-taker pilot will be proposed this year. Furthermore, they would like the pilot to include a flat-fee similar to what IEX charges.
In their blog, “Maker Taker Needs to Happen,” Messrs. Saluzzi and Arnuk illustrate how rebates can create a conflict of interest for algorithms executing a VWAP slice.
Running the pilot will be important to institutional investors who worry that their brokers are focusing on strategies to gain rebates more than seeking best execution.
Opposition to Maker-Taker
“Buy-side firms are skeptical of the maker-taker pricing model believing that it skews brokers’ routing incentives in favor of best rate as opposed to best execution,” said Richard Johnson, senior analyst at Greenwich Associates on a Dec. 16 webinar hosted by the Stamford, Conn.-based research firm. The rebates are seen as fuel for high frequency trading firms, said Johnson.
Fifty-five percent of buy-side traders think that maker-taker should be abolished in favor of a flat-fee price model, said Johnson referring to a Greenwich study of 400 U.S. buy-side traders. Other choices included a reduction in access fees and that the SEC should conduct a pilot program to determine the most effective model.
Only 5% of buy-side traders responding said they were happy with the current maker-taker pricing model, said Johnson. “Without the complex web of multi-layered pricing structures across multiple venues, there would surely be less focus on speed and the routing and rerouting of orders that frustrate traders,” he said.
However, maker-taker came about because the previous system was broken.
The practice has been controversial since it began with the Island ECN in 1997, but has been adopted by every stock exchange and many dark venues. It’s associated with high-speed trading and fragmentation. But has also helped exchanges compete with rivals for liquidity and reduced trading costs.
Hedge funds and quant trading firms can earn rebates if they post limit orders that add liquidity to an exchange or dark pool, said Johnson. However, brokers usually do not pass on these fees to traditional asset managers. Even if brokers passed on the fees, it could still be a problem for the buy side.
Asset managers would like to see the elimination of maker-taker, but they will not get that in the pilot, said Johnson.
The popular choice for the buy side is abolishing maker-taker and going for a flat-fee structure, said Johnson. Or, the other option is trying to limit the access fee — the amount of rebate from .003 per share (or 30 cents per 100) to a lower number. This would reduce market making and high frequency trading to some extent, but it will also result in higher costs, said Johnson.
Capping Access Fees
The EMSAC recommendation is for capping access fees, explained Eric Noll, president and CEO of Convergex, who is a member of the committee and has recently released an analysis of the tick pilot. Access fees today are 30 mils (or 30 cents per 100 shares). Today, exchanges can use that money to pay a rebate. For example, on Nasdaq and on other exchanges, someone who removes liquidity is charged 30 mils, while the exchange can then use 28 mils to pay a rebate to a market maker as incentive to provide liquidity. The idea is not to eliminate maker-taker, but rather to test maker-taker at different price bands.
Instead of a 30 mil cap, EMSAC is proposing 20 mil cap for a set group of stocks, then a 10 mil cap for a another set of stocks, and a third group with a 2 mil cap, said Noll.
“So by running the pilot across different bands, you will see whether maker-taker is positive for liquidity provision, negative for liquidity provision or creates distortions or eliminates distortions,” said Noll in an interview. By checking bids and offers at different price bands, one can tell if bid/offer spreads tighten or widen, does information leakage happen more frequently or less frequently, and whether bid-offers become more stable or more fragile, added Noll.
Order Protection Rule
Another aspect of Reg NMS that has been questioned is the order protection rule, which prevents exchanges from trading through a better-priced order on another exchange. This was a popular rule at the time it was implemented with Reg NMS because investors could receive a worse execution depending on where they routed an order, said Johnson. Exchanges could trade-through a better price at another exchange. The order protection rule was based on the idea that lit markets had protected quotes and contributed to price discovery. A side effect was that firms tried to avoid fees and visibility on lit markets, which then led to an increase in dark pool trading from 24% in 2007 to 37% today, noted Johnson.
In response, some participants are asserting that trading priority should be given to orders that contribute to price discovery and have proposed a Trade-At rule. This would entail modifying the order protection rule to prevent trading in venues at the national best bid and offer (NBBO), unless these venues were quoting publically at this price.
Though less than a majority, 45% of buy-side traders polled, favored replacing the trade-through rule with the trade-at rule, while 20% said no and 35% did not answer. It should be noted that this survey was taken prior to the tick pilot.
However, Noll doesn’t see the buy side wanting a Trade-At rule. “In fact most of the buy side would be opposed to a trade-at rule,” he said.
“Exchanges would like a trade-at rule, which would give the lit market primacy over the dark market,” he said. Long-only asset managers tend to believe that the maker-taker creates artificial liquidity and distortions in pricing, he said.
“They tend to believe if maker-taker is eliminated, then it would lead to more stable bid-offers, less artificial liquidity, less price volatility and increased trade sizes.”
Regulators reviewing the market structure will be able to analyze data from the tick pilot, which contains a trade-at rule in the third test group. [See Sidebar — Early Results: Tick Pilot, Trade At & Dark Pools”]
As the SEC transitions to a new administration, there is naturally some uncertainty over its priorities. It remains to be seen whether the acting SEC commissioner and staff will push through the maker-taker pilot, or wait for the new chairman to settle in and spearhead a broad holistic review of Reg NMS.
SEC Republican Commissioner Piwowar could instruct the SEC staff to begin a broad review of Reg NMS before the new agency head arrives. Piwowar may ask the agency staff to review the 2005 Reg NMS framework that regulates U.S. stock exchanges along with corporate disclosure rules under Dodd Frank, according to Bloomberg in “Interim SEC Boss Goes Beyond Caretaker Role to Revisit Rules.” At the Baruch Financial Markets conference in November, Piwowar said he might conduct a roundtable on the small tick pilot after it was operating for six months to review the results with participants in case it needed tweaking. But, when asked if the SEC would move forward with the maker-taker pilot, Piwowar responded, “Possibly. I hope so.”
One ominous sign is that the EMSAC charter was renewed but it was renewed for only six months. The original charter was for two years, said Noll. But, the SEC has kept the EMSAC Committee around to review pieces of Reg NMS, such as the trade- though-rule and a block exemption for institutions. EMSAC’s charter could be extended beyond June depending on the SEC’s goals. Time will tell whether Trump’s new SEC Chairman has the appetite to tackle an overhaul of Reg NMS.
Early Results: Tick Pilot, Trade At & Dark Pools
Convergex released its analysis for the small cap tick pilot on Jan. 4, covering the period from Nov. 1, 2016 to Dec. 13, 2016.
So far, results are mixed for the tick pilot: Bid-ask sizes are larger and trade sizes have grown, but look for wider spreads, higher volatility, and increased trading in dark pools, according to the institutional broker.
Transaction costs are also higher across all tick-size pilot groups. Measured as an increase in spread in terms of basis points, they are as follows: Group 1, 32.5%, Group 2, 33.8%, Group 3, 43.5%.
Wider Spreads: Flight to Dark Pools
Convergex’s analysis showed that widening spreads to a nickel has resulted in volume moving to dark pools – except in Group 3, which contains the Trade At provision.
In Group 1, stocks can trade at any spread but must be quoted in nickels, whereas in Group 2, stocks must be quoted in nickels, but people can trade off-exchange at the nickel or at the midpoint.
Early results also show more price volatility in tick pilot stocks. While volatility in the control group showed a 6% decline in volatility after Nov. 1st, test Group 1 was 27% more volatile, Group 2 was 20.9% more volatile and Group 3 was 23.1% more volatile.
Volatility in test Group 3 is coming from information leakage from the trade-at rule, which has always been a worry, said Eric Noll, president and CEO of Convergex.
In terms of how wider spreads and incentives are influencing order-routing behavior, Convergex found that market makers are routing their orders to “inverted venues” to capture rebates for taking liquidity and for queue positioning.
Past blog posts related to SEC regulation issues:
A Tale of Two Pilots: Maker-Taker and the Tick Pilot
The SEC’s ATS Transparency Rules: What’s the Impact?
Raising the Curtain on Treasuries