The CBOE Stock Exchange is altering its fees to win market share in lower-priced equities from dark pools and bigger venues such as NYSE Euronext and Nasdaq OMX Group Inc., according to Chief Executive Officer David Harris.
The exchange will pay firms 14 cents per 100 shares for orders in Citigroup Inc., Bank of America Corp. and 22 other securities that execute against buy or sell requests already on its platform. The next-highest rebates for those customers, known in the securities industry as takers of liquidity, are 2 cents on EDGA Exchange and 1 cent on Nasdaq OMX BX. CBSX is owned by CBOE Holdings LLC in Chicago and a consortium of financial firms.
Equity exchanges instituted fees and rebates in the last decade to attract brokerages whose traditional way of making money, capturing the spread between bid and ask prices, was squeezed as price increments narrowed. The model, known as maker-taker pricing, usually rewards brokers and investors who put requests to buy and sell shares in an exchange’s book and charges those who execute against them. EDGA and BX switched course, charging liquidity providers and rebating takers in an effort to target price-sensitive customers.
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“There’s a large amount of flow we’re not interacting with,” said Michael Bleich, chief executive officer of Scout Trading LLC, a market-making firm in New York. Instructions to buy or sell stock from discount brokers, mutual funds and asset managers often don’t reach public markets until they’ve passed through other venues including certain brokers and dark pools, which don’t display orders, he said.
“Having an exchange pay a rebate to liquidity takers is a nice way to address that issue by attracting those orders,” said Bleich said, who previously ran a nine-person electronic market-making group at Barclays Plc in New York.
Bleich left Barclays in 2009 with his team to form Scout, which trades on Nasdaq Stock Market, Bats Exchange and CBSX, and plans to expand. Bleich and his group earlier worked at Lehman Brothers Holdings Inc., where he was head of liquidity strategy. Bats Exchange is run by Bats Global Markets in Kansas City, Missouri. BX is owned by Nasdaq OMX in New York and EDGA by Direct Edge Holdings LLC in Jersey City, New Jersey.
CBSX’s goal is to win market share by getting to the top of the so-called routing tables brokers use to decide where to send orders, according to Harris. Where an exchange stands on the list depends on price, how quickly the order is likely to be filled, and how much liquidity is available at the best price on that venue, among other considerations. The new pricing goes into effect on Aug. 16.
“We’re attracting takers of liquidity,” Harris said. “That includes retail-sending firms that are looking to monetize their retail flow, participants who use dark pools and proprietary trading firms. Nobody at publicly displayed markets has gone this far in rebating takers.”
Most exchanges pay liquidity providers 20 cents to 30 cents per 100 shares and charge those trading against orders up to 30 cents, the maximum allowed by regulators. For the 24 securities with new pricing, CBSX will charge liquidity providers such as Scout 18 cents to interact with incoming orders for which it rebates 14 cents, earning 4 cents. For other shares it will continue to pay providers 25 cents per 100 shares and charge takers 30 cents.
For Scout, the attraction of paying to provide bids and offers is the ability to interact with orders it couldn’t trade with before. Trading requests from individual investors and institutions are considered less risky for market makers because they don’t usually seek to profit from split-second changes in a stock price.
“A lot of that flow never makes it to the public market,” Harris said. “We think by incenting the takers, they have to think hard about where they send their order flow.” CBSX worked with market makers to devise pricing that would appeal to firms seeking liquidity and those providing it, Harris said. CBSX has about 175 member firms trading on its exchange.
CBSX chose stocks with a high level of average daily volume and low prices. Stocks like Citigroup often trade between the bid and ask prices in dark pools and through what’s called internalization at brokers, Harris said. Yesterday, 36.7 percent of Citigroup’s 336 million shares traded off exchanges, more than the total on the three largest markets for the bank’s stock, according to Bloomberg data. CBSX’s share of trading was 0.01 percent, the data showed.
Buy and sell requests from discount brokers that can trade immediately are usually sent to market makers that internalize them -- executing against those orders away from exchanges at prices that often exceed what’s available publicly -- or to dark pools such as Getco Execution Services, run by Getco LLC in Chicago. Units of Citadel LLC in Chicago, Citigroup in New York, Zurich-based UBS AG and Knight Capital Group Inc. in Jersey City, New Jersey, internalize orders from discount brokers, who are usually paid for the buy and sell requests they send.
Orders from institutions including mutual funds are often sent to broker-run dark pools to seek executions that are less likely to move the stock price and are less costly. They may seek trades in a half-dozen or more dark pools before reaching the public market. High-volume, low-priced stocks are more likely than higher-priced stocks to be executed away from exchanges.
“For a stock like Citigroup, an exchange can give a high rebate to takers and still have market makers earn a healthy profit while paying to provide liquidity,” Bleich said. “It’s a low-priced stock and has a really huge spread in percentage terms.” A one-cent spread, or difference between the bid and ask prices, for a $25 stock is 0.04 percent of the share price. For a $4 stock, the same spread would be 0.25 percent, or about six times higher. The minimum one-cent spread on exchanges encourages firms to trade on other venues, Bleich said.
CBSX, which began trading stocks in 2007, accounted for 28 million shares a day in July. The CBOE unit, which is profitable, according to Harris, had a record day yesterday, trading 63.7 million shares. The exchange relies on its parent for technology and other support services.
“We are moving our market to be a lot stronger vis-à-vis other markets,” Harris said.