The pricing system used by the majority of U.S. stock exchanges should be banned because it encourages trading aimed only at collecting rebates, according to Jeffrey Sprecher, chief executive officer and chairman of IntercontinentalExchange Inc.
Regulators shouldn’t let venues offer maker-taker pricing, in which an exchange charges some firms to trade and gives others rebates, Sprecher said today at a Futures Industry Association conference in Chicago. He said the pricing structure discourages some traders from owning stock.
“Don’t allow us to pay for order flow,” Sprecher said of the exchange industry. His Atlanta-based company runs futures and energy markets. The pricing technique used in equities spurs some traders to “simultaneously buy and sell on two different exchanges” and get paid rebates on both, instead of making money by holding shares, he said.
The number of U.S. stock and options exchanges has risen to 13 and nine, respectively, and one way they try to differentiate themselves is with pricing plans. Maker-taker pricing is mainly used to compensate market makers and other providers of bids and offers, while traders who execute against those orders pay a fee. Most futures exchanges charge trading fees and offer no rebates.
The maker-taker system is reversed on some markets to pay firms that trade against orders supplied by market makers or others who are charged a fee. That pricing, called taker-maker, in conjunction with the more popular structure may allow traders to be paid to supply orders on one market and get rebates when they trade against bids or offers elsewhere.
Cameron Smith, general counsel at Quantlab Financial LLC, a Houston-based quantitative research and trading company, said in an interview that there’s no need to eliminate maker-taker pricing. The system was initially employed by Island ECN, a trading platform that began competing with Nasdaq Stock Market more than a decade ago. Smith was Island’s general counsel from 1999 to 2002.
“He’s saying some firms’ revenue is tied to the rebate,” Smith said of the ICE executive’s comments. “In futures and in Europe, there are plenty of markets that don’t have rebates and yet these same firms are able to trade profitably.” The rebate isn’t the reason most firms providing liquidity trade, he said.
Competition among market makers and providers of liquidity reduce the difference between the highest bid price at which people are willing to buy shares or contracts and the lowest level at which they’ll sell, called the bid-ask spread, Smith said. The rebate is among the factors considered by firms whose computers decide what quotes to publish. If maker-taker pricing ends, “the firms will just adjust to the new pricing structures and that adjustment will result in wider spreads,” he said.
Wider spreads increase trading costs for institutional and retail investors and may encourage orders to be sent to dark pools or private venues that don’t display prices, Smith said. Dark pools, many of which compete with exchanges and trade at the midpoint between the best bid and offer, can save investors more money when spreads are wider.
Sprecher said pricing structures like maker-taker may also dissuade providers of liquidity from remaining in markets when volatility increases. Some firms pared back or stopped supplying orders during the May 6, 2010, plunge when $862 billion in equity value was briefly erased in about 20 minutes during the so-called flash crash, according to a report last year by the Securities and Exchange Commission and the Commodity Futures Trading Commission.
James Overdahl, vice president at NERA Economic Consulting and a former chief economist at the SEC and CFTC, said the report produced by the two regulators last year didn’t cite maker-taker fees among the factors that contributed to the May 6, 2010, plunge. The agencies found that the cause had “more to do with fragmented rules and a fragmented marketplace,” he said in an interview.
“It was after the market was down and market data was inaccurate that a handful of institutions withdrew from the market,” Smith said. What Sprecher said “reverses cause and effect.”
Following the plunge in May 2010, exchanges and regulators have considered how to ensure that sufficient liquidity remains in markets when volatility increases. Among options raised by regulators in the U.S. and Europe are boosting obligations on market makers and mandating that quotes remain in the market for a specified amount of time.
U.S. regulators have increased some market-making quoting responsibilities, clarified rules about when trades are canceled to make them more uniform, and established curbs that pause trading when prices rise or fall more than a certain amount.
Craig Donohue, chief executive officer at CME Group Inc., said at the futures conference that the securities markets need to develop “bumpers and speed bumps to help to ensure market integrity.” While regulatory scrutiny should also focus on “abusive trading practices and behaviors,” adding obligations on market makers isn’t necessary, he said.
“We’ve seen obligations in the past on specialists and market makers,” Donohue said. “They generally don’t work.” Futures markets, in contrast to securities markets that have imposed trading obligations on market makers in the past, are liquid and have no “affirmative obligations ever,” he said.