Every now and then we like to remind the industry who actually pioneered payment for order flow in our market structure. Yes – Mr. Madoff!
Anyhow, this morning we want to highlight the works of Professor Lawrence Harris (USC Marshall). You should already be familiar with a 2010 paper he co-authored with Georgetown’s James Angel that we have highlighted on many occasions in the past – Equity Trading in the 21st Century. That paper came to several conclusions, most notably that maker-taker pricing has distorted price discovery – trades are taking place at prices that differ meaningfully from stocks’ true point-in-time values.
Harris has another paper out just this last month that delves deeper and looks into the effects of maker taker pricing on quotations. Titled Maker-Taker Pricing Effects on Market Quotations, Harris again assails how this pricing scheme distorts trading in stocks. He makes five points:
- Maker-taker pricing creates an agency problem between brokers and their clients when the clients do not receive the liquidity rebates or when business models prevent brokers from passing on the access fees.
- Maker-taker pricing creates a transparency problem since quoted spreads are different from the more economically meaningful net spreads and since most retail traders are unaware of the difference.
- Maker-taker pricing and its recent variant, taker-maker pricing (discussed in the conclusion), represent a means by which exchanges can permit net quotes on subpenny increments. These pricing models thus represent loopholes through which exchanges and their more sophisticated clients can subvert the prohibition on subpenny quotation pricing in Regulation NMS. This loophole allows sophisticated electronic traders to front-run buy-side traders.
- Maker-taker pricing increases incentives to route market orders for execution in venues that do not charge access fees. These venues include dealers who internalize their client order flows, dealers who pay brokers to preference their customers’ orders them, and various dark pools that match buyers and sellers.
- Finally, maker-taker pricing makes markets unnecessarily complex at the cost of creating agency problems and without the benefit of adding any positive value. Financial risk managers trained in systems engineering recognize that complexity is an important cause of systemic risk. The additional complexity associated with maker-taker pricing works against efforts to reduce systemic risk.
Harris uses September 2012 trading data from NYSE’s TAQ (1-second data), and we humbly think even more can be learned by looking at data from the proprietary data feeds – i.e. the story of what goes on in the sub-second world. Harris’s data also uses a flawed NBBO calculation (quotes sizes are only derived from the first setting market, and not an aggregate of all lit venues), which he states he will correct in a subsequent study. In addition we think studies such as his should incorporate the signaling and pinging that takes place in dark venues alongside of what is transpiring in the lit markets – the two are extremely related. Market makers are playing rebate arbitrage and picking bid and offer prices to leg into in very sophisticated ways – more so than just looking at the relative size of the bids and offers on lit exchanges.
Nevertheless, his conclusions have merit. Trading motivated by rebates does distort price discovery, and we see this every day. Here is a war story from yesterday:
We were buying a large number of shares of a large cap tech company that trades tens of millions of shares per day. During one stage of the order, while we trying to feel the real supply and demand of the stock (the stock was “heavy”), we were bidding manually for the stock on several exchanges at 39 cents. Of course, the real data feeds quickly had us pegged as NOT being market-making computer flippers – or rather as static slower order flow – or “takers”. The NBO quickly built up large at 40 cents– knowing that there was a high probability of the “taker” – us – taking their 40 cent offers, which would earn them a 33 mil rebate.
However, we knew the stock was heavy, despite the 40 cent sellers not willing to hit our 39 cent lone bid, as they did not want to incur a take fee. So we canceled and replaced to 38 cents. They adjusted to size offered at 39 cents. Again they would not hit our 38 cent bid and incur the take fee. We adjusted to 37 cents. And then 36 cents. And then 35 cents. All the while they adjusted their sizeable offers downwards – they would rather sell stock at 36 cents and get a rebate, rather than sell it at 39 cents and pay a take fee. How is that for price discovery?
We took their 36 cent offering, incidentally, and cheerfully paid our take fee.
Sadly, our trading experience from yesterday reflects what all of us know as daily practitioners – quote sizes and prices in the markets have much more to do with a game of rebate optimization than they do about true supply and demand. If the visible markets acted rationally, according to real laws of supply and demand, they would have hit our bids at 39 cents rather than selling lower at 36 cents.
Back to Harris’s paper. We like his conclusion:
If everyone could see through the transparency problem, and everyone could control the various agency problems created by the maker-taker and taker-maker pricing schemes, these pricing schemes would present no public policy concerns. If not, the SEC should consider restoring the simple traditional fee-based exchange pricing standard. Doing so would eliminate much unproductive game playing while strengthening exchange incentives to attract order flow by offering competitive fees for their services.
The SEC has long stated that their goals are to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Corollary to those goals is a marketplace which reflects true price discovery. At some point it is inevitable that they must examine from a big picture standpoint how payment for order flow in general, and maker-taker pricing specifically, has taken the markets away from their own goals.