CBOE Breaker Maker Taker
As we write this, 60 Minutes is re-airing its piece from last year on high frequency trading, The Speed Traders, which included Joe, SEC Chairman Mary Schapiro, Senator Ted Kaufman, Larry Liebowitz of the NYSE, as well as Manoj Narang of Tradeworx, the only high frequency shop that would speak with 60 Minutes. They are re-airing and updating the story to add what has been done since May 6th, and since they aired their story last fall.
Well, since that story much has happened, although sadly precious little of it has been on the regulatory front.
Since the airing of 60 minutes, we have all witnessed:
– Countless individual flash crashes
– Exchanges experiencing rapid margin contraction due to HFT.
– HFT experiencing substantial margin pressure (that’s what happens when you Jump The Shark).
– Major dark pools cutting jobs in force.
– Rapid push towards derivatives by the exchanges and HFT’s to get out of the barren cash equity space.
– Exchanges merging, and scrambling to merge.
One exchange, the CBOE (CBSX) has been innovative in trying several tinkerings with the for-profit exchange model to find a niche for themselves. Just this past June 1st, they altered their pricing away from the maker-taker model they have utilized since their inception in May 2007. Instead of rebating the “adding of liquidity”, and charging for the “taking of liquidity”, they will move towards a flat fee to trade, whether you add or take (see CBSX new fee schedule here). This is highly significant, and we’ll tell you why we think so towards the end of this note.
We wanted to understand why the CBOE made this change, so we contacted David Reed, a senior executive at the firm. He graciously gave us a significant amount of his time to explain the pricing. David knew our firm had butted heads with his firm in the past, about market structure issues, as well as other philosophical differences, yet he generously spoke with us. He was honest to a fault in assessing less successful moves the CBOE has made in the past, and we are grateful that we reached out to him.
While the CBOE initially had as its target market “cross product traders”, as opposed to rebate-arbitrage players (the big HFT shops) and the internalizers, the stock exchange environment has become ultra-competitive. To stay competitive, the CBOE has had to play along in the speed race (it moves into a New Jersey data center on July 1st, FYI), as well as prove itself more nimble than its larger and more bureaucratic rivals. Its management team is definitely not afraid to take risks and try new things, and they have proven it, specifically with regard to pricing. Witness:
– Last August it commenced a highly original Inverted Pricing scheme oriented towards specific stocks. For example, Citigroup was a stock that you would receive a rebate from the CBOE from, if you took liquidity on the CBSX, rather than “provide” it. We thought this pricing innovation was wrong-headed, and we told David that on our call.
– This past Wednesday, June 1st, CBSX went to a flat pricing scheme.
The CBOE’s move confirms to us just how hard the exchange space is, and how much the pendulum has been swinging back of late towards the interests of investors, as opposed to traders. And we like this move a lot. We have never been fans of maker-taker pricing, as we feel it distorts trading, pricing, and asset values in the market place.
The CBSX moving to flat fees is great for investors for two meaningful reasons.
First, it takes conflicts of interest out of the routing game played by every major brokerage firm. If you are working a million shares to buy in an algorithm, liquidity on the CBSX will theoretically be there because it is natural, and not because it wants a rebate, or because it is signaling. David Reed explained to us, “We all know that in the current maker-taker model, consolidated order-flow rests mostly at high-rebate exchanges and typically executes when adversely selected, as if the liquidity is on the moon. What we are trying to do is cater to more natural order flow by setting rates flat. If a small, stable share of participants is finding value, than it is a win for everybody.”
Second, we have always been comfortable with a market in which folks buy because they think a stock is going higher, and sell when they think it is going lower. When the motivations of over half of the market do not follow that simple basic premise, values get distorted in the general market.
We, as capitalists and believers in the American Way, know all too well that the market responds more quickly than the government in filling needs. It so happens we have been in need for a long time to return to some basic focuses for our equity markets. We think the CBSX’s switching of its pricing model may help fill this need, and we hope every exchange follows their lead. Every one.