We have often criticized the exchanges for not doing more to reign in abusive practices at their venues. One thing which we have cited that the exchanges can do is to implement a cancellation fee. This fee would discourage nefarious practices such as quote stuffing, layering and spoofing.
Little known is the fact that Nasdaq did implement a cancellation fee known as the Excess Order Fee in 2012. When they first implemented the fee, Nasdaq stated:
“Inefficient order entry practices may place excessive burdens on the systems of NASDAQ and its members and may negatively impact the usefulness and life cycle cost of market data. Market participants that flood the market with orders that are rapidly cancelled or that are priced away from the inside market do little to support meaningful price discovery.”
Sounds like a good idea but apparently the fee was quickly circumvented by the firms that it was meant to punish. Now, Nasdaq has filed with the SEC to modify the Excess Order Fee to try and plug the loophole that some firms found:
“NASDAQ is now proposing to modify the fee, such that it will be calculated and assessed on the basis of all of a member’s trading activity on NASDAQ, rather than on an MPID basis. The purpose of this change is to ensure that members do not act in a manner inconsistent with the intent of the fee by spreading inefficient order activity across multiple MPIDs in a manner that allows the MPIDs to avoid a charge that would not be avoided if all of the member’s activity were aggregated.”
We were just about to break out the “kudos to Nasdaq” line and then we discovered a small detail which gives us serious doubt about the effectiveness of the Excess Order Fee:
“Orders sent by market makers in securities in which they are registered, through the MPID applicable to the registration, are excluded from both components of the ratio.”
Nasdaq has exempted market makers from the fee because they claim that “market makers are already subject to rule-based standards designed to promote the efficiency and quality of their order entry practices (Rule 4613). But exactly what does Rule 4613 say about market maker quoting obligations? It says that “market makers” are not allowed to quote more than a designated percentage away from the last trade. And what is that designated percentage you ask? It’s at least 8% and could be as much as 30% away from the last trade (depending on the stock).
“For purposes of this Rule, the “Designated Percentage” shall be 8% for securities subject to Rule 4120(a)(11)(A), 28% for securities subject to Rule 4120(a)(11)(B), and 30% for securities subject to Rule 4120(a)(11)(C), except that between 9:30 a.m. and 9:45 a.m. and between 3:35 p.m. and the close of trading, when Rule 4120(a)(11) is not in effect, the Designated Percentage shall be 20% for securities subject to Rule 4120(a)(11)(A), 28% for securities subject to Rule 4120(a)(11)(B), and 30% for securities subject to Rule 4120(a)(11)(C). The Designated Percentage for rights and warrants shall be 30%.”
Think about that. If you were a “market maker” in AAPL (which is trading around $460), then your quoting obligation would be a bid of $423 and an offer of $496. We understand that exchanges want to encourage market makers to “provide liquidity” and adding a cancellation fee could damage the economics of some of their market makers. But why should a market maker get the benefit of being exempt from these fees if they have little or no obligations to maintain reasonable quotes?