U.S. Equity Rebates, Part 2
In the last Trading Places newsletter, we discussed the origin of rebates in the U.S. equity markets. Rebates began as a marketing tool for Island to attract order flow to its new new trading venue. The model was so successful that within five years, Island was 20% of the trading volume in NASDAQ-listed stocks, and the entire market had adopted Island’s maker-taker system. Two decades later, people are looking more closely at the implications of this structure.
“Kickbacks”
Brad Katsuyama, CEO of IEX, kicked up a storm recently by calling rebates “kickbacks,” in his testimony before the U.S. House of Representatives Committee on Financial Services.
[Rebate] payment to brokers when not shared with the broker’s client is equivalent to a kickback. Public data shows that exchanges who pay this rebate garner a greater percentage of order flow despite providing worse execution quality.
As we discussed last week, the controversy of keeping rebates was an accident of the bank broker-dealers moving from principal execution (trading directly with buy-side clients) to agency execution (executing on a customer’s behalf using automated execution algos). Brokers, not customers, had the exchange relationships, paid any access fees and kept any rebates.
By starting the conversation with the phrase “kickback,” Katsuyama increases the temperature of the discussion. Matt Hurd talked about this on his blog, “[Kickback] is not a term that should be used lightly, … Such aspersions are why the debate gets heated on both sides leading to a lack of rational rationale.”
A couple of Yale Professors piled onto the “kickback” charge with a NYTimes’ op-ed:
[B]rokers routinely take kickbacks, euphemistically referred to as “rebates,” for routing orders to a particular exchange. As a result, the brokers produce worse outcomes for their institutional investor clients — and therefore, for individual pension beneficiaries, mutual fund investors and insurance policy holders — and ill-gotten gains for the brokers.
And now the Massachusetts is launching an inquiry into “kickbacks” with IEX and the Yale op-ed being specifically cited as the reason:
“If financial rebates or kickbacks create a conflict that results in less than the best deal for the investors, this practice must stop,” said Mr. Galvin, who oversees enforcement of the securities laws of Massachusetts.
The investigation was prompted by a July opinion piece in the New York Times , Mr. Galvin said … Mr. Galvin also cited recent criticism of rebates by IEX Group Inc., the upstart stock exchange made famous by Michael Lewis’s 2014 book “Flash Boys.” IEX doesn’t pay such rebates.
Even Xavier Rolet, CEO of the London Stock Exchange, called rebates a “form of corruption” in my twitter conversation with him. (Psst, you own Turquoise, which pays rebates.)
SEC Access Fee Pilot
The rhetoric is overblown, but it is clear that momentum is building toward a great rethinking of many aspects of the U.S. equity market structure. The new SEC chair, Jay Clayton, recently said he is inclined to experiment.
One recommendation where there is broad consensus to proceed is the launch of a pilot program to test how adjustments to the access fee cap under Rule 610 of the Securities Exchange Act of 1934 would affect equities trading. Such a pilot should provide the Commission with more data to assess the effects of access fees and rebates — including “maker-taker” and other pricing systems — on liquidity provision, liquidity taking, and order routing.
Exchange access fees are currently capped at $0.30/100 shares (from now on referred to as 30 mils, 1 mil = $0.0001). The SEC pilot would lower the access fees for different buckets of securities to 20, 10, and 2 mils. The pilot would not ban rebates, but the lower fee would encourage exchanges to lower rebates commensurately so as to not lose money on trading fees. Annie Massa has a lot more on the details in her recent Bloomberg article.
At a 20 mils fee cap, there probably will not be much change in market structure. Removing liquidity costs the full access fee of 20 mils. Adding liquidity moves the rebate down from 28–30+ mils (depending on the tier) under the current regime to 18–20+ mils with the new access fee cap. Exchanges still make approximately the same fee revenue and the economics for using alternative execution venues (e.g., dark pools) do not change enough to see significant market share changes.
At the other end of the spectrum is the 2 mils fee cap, which could change the incentives of market participants significantly. A low fee cap also would be bad for IEX, as it makes quite a bit of fee revenue compared to its peers. IEX charges a net of 18 mils (9 mils to the buyer and seller) on every trade in its dark order book (80% of IEX’s volume) compared to a net of ~2 mils for most exchanges (e.g., 30 mils fees — 28 mils rebates). IEX likely would get more volume in their lit order book, but it seems unlikely that would make up for the lost fee revenue in the dark order book.
Banning Rebates
The reduced fee income is at least part of the reason why IEX’s goal is not to reduce the access fees but instead to ban rebates entirely. From Brad’s testimony:
In short, rebate practices cause clear and significant harm to investors. In addition, they are inextricably linked to much complex regulation that, although designed to serve the interests of investors, has had unintended consequences and could be reduced or eliminated if this conflict is removed.
What is likely to happen if rebates are banned? The equity market is highly complex with over 50 venues on which to trade, so no one is certain. However, I spoke with a half dozen people who think about equity market structure all day long at exchanges and high-frequency trading firms to get their thoughts.
One person thought that exchanges might not end up cutting prices at all. “Why not keep the money!” NYSE and NASDAQ have healthy sources of revenue from listings, co-location, and market data. The public exchanges could cut prices today if they wanted to, but they have not done so, likely because there is very little market pressure in an oligopoly where three companies (NYSE, NASDAQ, BATS) own nearly all the volume.
Many colleagues thought that execution would become free across exchanges. Exchanges no longer pay a rebate to liquidity providers so free is the next best incentive. As a consequence of no rebates being paid, the fee for removing liquidity is crammed down to zero. Volumes would soar at dark pools and wholesalers (the Citadels and Virtus of the world who are on the other side of your E*Trade order). Dark pools have far more flexible fee schedules that can even be customized on a customer-by-customer basis. These venues would no longer have to compete against a 28–30+ mils subsidy at the exchanges.
Dave Lauer, a market reform advocate who is in favor of banning rebates, believes that the SEC needs to look at rebates in the larger context of reforming the U.S. equity markets. He believes that you cannot address rebates without also looking at payment for order flow and meaningful price improvement at dark pools.
All of these are complex issues. Any reform in isolation likely would have a lot of unintended consequences, so there should be careful consideration and debate before any action is taken to actually ban rebates.
