Nasdaq Stock Market asked the U.S. Securities and Exchange Commission to allow companies sponsoring exchange-traded funds to pay market makers about $200 per day to quote their shares more aggressively.
The practice, currently illegal in the U.S., would spur quoting and transactions in ETFs that trade less than 2 million shares daily, benefiting investors by making more volume available to buy or sell at better prices, Nasdaq told the SEC in a filing published on April 6. The exchange said it would begin the program, which regulators must approve before it can be implemented, as a one-year study. The SEC rejected two earlier requests before they reached the public comment stage.
U.S. exchanges are seeking ways to boost the number of shares that can be bought or sold at or near the best prices in less-active securities. Executives from Nasdaq OMX Group Inc. and NYSE Euronext in New York told members of Congress in hearings in November that they intended to propose pilots enabling issuers to pay market makers for their services, mimicking efforts employed in Europe for smaller corporations.
“If ETF issuers want to incentivize market makers for services they provide, there should be mechanisms in place for that,” Reginald Browne, co-head of the ETF group at Knight Capital Group Inc. in Jersey City, New Jersey, said in a phone interview. “With more than 50 markets in the U.S., there’s just not enough incentive for market makers to bear the risk.”
Knight makes markets in more than 625 ETFs on Nasdaq, NYSE Arca and BZX Exchange. The company is also one of the main market makers for companies on NYSE and owns almost 20 percent of Direct Edge Holdings LLC, an exchange operator in Jersey City, New Jersey. Browne said the fees issuers pay should be negotiated instead of standardized, as Nasdaq is proposing.
There were more than 4,200 exchange-traded products globally with $1.52 trillion in assets at the end of 2011, compared with 106 with $79 billion in 2000, according to data compiled by BlackRock Inc. Of the 1,098 U.S. ETFs, fewer than 10 percent traded more than $40 million a day, the data showed.
“It’s a tough problem they’re trying to solve,” Michael Bleich, chief executive officer of Scout Trading LLC, a market-making firm in New York, said in a phone interview. About 70 percent of Scout’s volume is in ETFs. “Investors looking at a new product may want to invest but someone must provide a liquid market,” he said. “In the ecosystem of trading activity, it may not be profitable for market makers, including ourselves.”
Nasdaq’s program would give ETFs that might otherwise languish a chance to build volume and attract buyers by providing better prices, Browne said. While products that later fail to draw assets may not have appealed enough to investors, they at least would have had a chance, he said.
The Financial Industry Regulatory Authority, which oversees more than 4,400 U.S. brokers, banned payments to market makers in 1997 to improve investor confidence. Finra said at the time that the decision to make a market in a security should be based on supply and demand, the firm’s expectations about trading, its inventory of shares, and competition. It shouldn’t be influenced by payments from issuers, the regulator said.
Finra plans to exempt market makers in exchange programs approved by the commission from the prohibition on taking payments, Nasdaq told the SEC.
Tim Quast, founder of ModernNetworks IR LLC, a Denver-based consulting firm that advises EMC Corp. and other companies about market structure and equities trading matters, said in a phone interview that exchanges shouldn’t be allowed to treat issuers differently and that payments to market makers shouldn’t be used to stimulate liquidity.
“Trading shouldn’t be incentivized in one security in a different way than it is for other securities,” Quast said. He said he doesn’t support payments to market makers to narrow the difference between bids and offers, price bands, trading curbs or other rules that limit share moves. “All these are price-control mechanisms that conform behaviors to norms, which exacerbates arbitrage and diminishes investment and capital formation,” he said.
Regulations adopted in the last decade have driven up costs for companies that want to sell shares and shifted trading incentives toward higher-capitalization stocks, according to a report in October by the IPO Task Force, a group of private securities professionals. President Barack Obama signed into law legislation on April 5 that seeks to ease companies’ access to capital and initial public offerings as a way to create more jobs.
Nasdaq OMX has had “great success” in increasing liquidity in stocks on its First North market, a European venue for smaller companies that has had a program enabling issuers to compensate market makers since 2002, Eric Noll, executive vice president for transaction services, said in a phone interview in November. The exchange operator will serve as an intermediary to collect payments for the new program from issuers and distribute them to market makers, he said.
Market makers operating on most U.S. exchanges generate revenue from the spread between bid and offer prices as they buy and sell shares and by incentives exchanges pay to spur liquidity. Joseph Mecane, co-head of U.S. listings and cash execution at NYSE Euronext, said at the November hearings that the company’s current liquidity payments for quoting often aren’t enough to compel market makers to trade more shares at narrower spreads.
“Allowing issuers to compensate market makers could help,” Mecane said at the hearings. If the results benefit investors by increasing volume, regulators should “try a second experiment with some stocks and see if it has the same effect,” he said.
NYSE Arca is talking to the SEC about a pilot program that would allow ETF issuers to pay market makers for providing bids and offers in their shares and “enhance liquidity in less-active securities,” Laura Morrison, head of the U.S. exchange-traded products listings and trading business at NYSE Euronext, said in a phone interview. Arca plans to submit its proposal in the “near future,” she said.
The SEC asked the public for comment about whether programs that worked for smaller companies outside the U.S. would be as effective for ETFs and how Nasdaq’s plan may affect the stocks in an index tracked by the fund. It also asked if the program raises conflicts of interest among issuers and market makers.
An ETF issuer in the program must pay Nasdaq a $50,000 annual fee, which the exchange will distribute to one or more market makers that qualify for the program each quarter, according to the filing. Firms can pay another $50,000 a year if they want to foster more quoting and trading. The payments are in addition to Nasdaq’s annual listing fee.
Market makers qualify for the program by maintaining bids for 500 shares and offers for the same amount at the best available prices for at least a quarter of the day, Nasdaq said. They must also supply quotes to buy at least 2,500 shares and the same number to sell no more than 2 percent from the national best bid or offer. That requirement must be met 90 percent of the time, Nasdaq said.
Nasdaq’s proposal echoes two earlier ones that the SEC rejected and didn’t publish for comment. SEC rejections at that stage usually occur for technical reasons such as an incomplete filing. While all the plans apply to ETFs, the newer requests limit the scope to more illiquid products and loosen some of the quoting requirements for market makers.
The current proposal and the one dated Jan. 18 confine the payment program to securities with an average daily volume of less than two million shares for three consecutive months, instead of five million shares a day for half a year in the November filing. Nasdaq expanded the initial requirement that market makers supply quotes for at least 5,000 shares no more than 1 percent away from the national best bid or offer to no more than 2 percent from the NBBO.
Amber Anand, a finance professor at Syracuse University’s Whitman School of Management in Syracuse, New York, who co-wrote a paper with two other academics in 2009 about paid-for market making on the Stockholm Stock Exchange, said smaller companies benefited from payments to market makers. The paper was based on an analysis of 50 companies between September 2002 and March 2004 that contracted with market makers to supply liquidity.
“They traded passively to provide liquidity when liquidity was scarce,” Anand said of the market makers in a phone interview. “When you create a band and say market makers can’t have a spread wider than the band, it also changes the behavior of other market participants. Spreads narrowed much more than market makers were contracted for.”