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SEC OKs Payments on Nasdaq for Making Markets in Some ETFs

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March 22 (Bloomberg) -- U.S. regulators approved Nasdaq Stock Market’s request to allow the sponsors of some exchange-traded funds to offer payments to market makers.

The Securities and Exchange Commission decision loosens a ban on the compensation that has been in place since 1997. Nasdaq OMX Group Inc., which plans to begin the program as a one-year pilot, argued along with NYSE Euronext before Congress in 2011 that payments to market makers may increase liquidity and improve prices to investors in less-active securities.

Approval of the program comes amid concern that stocks with lighter volume are suffering in America’s computerized equity markets because they are less attractive to automated traders. NYSE Arca, an all-electronic venue that competes with Nasdaq, submitted a request to the SEC yesterday for its own initiative. Payments for market making in smaller companies is allowed in some European countries.

“It will incentivize market makers to collect revenue by posting bids and offers at the exchange,” Chris Hempstead, director of ETF execution at broker WallachBeth Capital LLC in New York, said in a phone interview. “Market makers will compete with one another to capture that revenue stream and drive the bid-ask spread to a tighter band.”

Nasdaq sought last year to limit the arrangements to ETFs with average daily trading of fewer than 2 million shares and subsequently cut the threshold to 1 million. The exchange told the SEC it expects the Financial Industry Regulatory Authority, which oversees almost 4,300 U.S. brokers and bans payments by issuers to market makers, to allow its program.

Finra Ban

Finra imposed its prohibition almost 16 years ago to improve investor confidence. It said at the time that the decision to make a market in a security should be based on supply and demand, competition, the firm’s expectations about trading and its inventory of shares. It shouldn’t be influenced by payments from issuers, the regulator said.

“We’re happy to have the SEC’s support on what we consider a groundbreaking innovation in market quality for our ETF community,” Robert Madden, a spokesman for New York-based Nasdaq OMX, said in an e-mail. “Timing and details of the pilot will be announced.”

There were almost 4,800 exchange-traded products globally with $2 trillion in assets in February, compared with 106 with $79 billion in 2000, according to data compiled by BlackRock Inc. The 1,444 U.S. products accounted for $1.4 trillion of the total, the data show.

Million Shares

About 93 percent of U.S. ETFs and exchange-traded notes, a total of 1,342, traded fewer than 1 million shares a day on average in January and February, according to BlackRock data.

Still, ETF issuers, which have low expense ratios relative to other funds, ”may not be eager to start spending money on a hope and a prayer that the program will work,” Hempstead said. ”It will be interesting to see if they participate and which products they include in the program.”

Funds whose bid-ask spread is wider than their component stocks are more likely to be candidates for the program, he said.

At least 91 U.S. exchange-traded funds and notes closed last year, more than any other year, according to data compiled by Bloomberg. Money management companies such as BlackRock and Vanguard Group Inc. took products off the market that failed to generate investor interest after the total number of exchange-traded securities more than doubled to more than 1,400 in five years and assets expanded to $1.44 trillion.

Distortion Potential

SEC staff expressed concern in approving Nasdaq’s study that allowing payments has the ”potential to distort market forces because the program may act to artificially influence trading in ETFs.” The worries were mitigated by Nasdaq’s plan to submit monthly reports about the program to the SEC and public, among other precautions, the regulator said.

Exchange-traded funds and notes accounted for 14.9 percent of U.S. equity volume this quarter through March 20, according to data compiled by Bloomberg Tradebook. It reached a five-year high of 18.8 percent in the fourth quarter of 2008, data show.

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, head of U.S. equities at NYSE Euronext, said at the 2011 Congressional hearings that the company’s liquidity payments for quoting often weren’t enough to compel market makers to trade more shares at narrower spreads.

High Costs

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 2011 report by the IPO Task Force, a group of private securities professionals. President Barack Obama signed into law legislation last April that seeks to ease access to capital and initial public offerings as a way to create more jobs.

The SEC is poised to recommend a pilot program to test whether larger price increments than the current minimum of 1 cent for most U.S. companies will promote more active trading of smaller stocks. The agency is “working through the details” of the plan, John Ramsay, acting director of the trading and markets division, said in an interview.

Less Liquid

“The current market structure doesn’t cater to the less-liquid side of the market because it isn’t as profitable,” said Amber Anand, a finance professor at Syracuse University’s Whitman School of Management in Syracuse, New York, who has written about the benefits of paying market makers to supply liquidity on the Stockholm Stock Exchange. ”There’s a need for some kind of obligated liquidity provision in the market,” he said by phone.

Payments to markets makers are less of a “blunt instrument” in spurring liquidity than increasing the tick size, he said. “Here, issuers get to decide if they want more liquidity and they’d participate only if they see the benefits are higher than the costs,” he said.

Nasdaq said in the filing that it would consider expanding the program to smaller corporations if it boosts liquidity. That plan would need SEC permission to be introduced. Mecane said at the 2011 hearings that its initiative could be used for ETFs and less actively traded stocks if it benefits investors.

Bats Global Markets Inc. has a program to boost liquidity in ETFs it lists. It pays a daily rebate to market makers who are at the best available price for the largest number of seconds each day.

Annual Fee

An ETF issuer in Nasdaq’s program must pay the exchange a $50,000 annual fee, which the venue will distribute to one or more market makers that qualify for the program each quarter, according to the exchange. 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. Payments are distributed to market makers on a pro-rata basis that takes into account their quoting and trading activity.

Nasdaq initially asked the SEC to allow ETFs trading up to 5 million shares a day for half a year to be included in its program. The SEC approved a level of fewer than 1 million shares a day for three consecutive months.

Arca Plan

NYSE Arca’s proposed plan also covers ETFs and related products with fewer than 1 million shares traded a day, according to Laura Morrison, head of U.S. exchange-traded products and the global index group at NYSE Euronext. While some of the quoting requirements for market makers are the same as Nasdaq’s, its requirements for when they must quote at the national best bid or offer differ.

Arca’s ETP incentive program is a “high priority” and could start as early as the third quarter if the SEC approves it, Morrison said by phone. “Offering this as an option to issuers when they choose to list on our exchange provides an additional tool to potentially let them attract a lead market maker and potentially improve the market quality of securities traded on our exchange.”

To contact the reporter on this story: Nina Mehta in New York at nmehta24@bloomberg.net

To contact the editor responsible for this story: Lynn Thomasson in New York at lthomasson@bloomberg.net.

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