Maker-taker rebates now likely to be put under scrutiny by SEC

What a difference a year makes.

What looked unlikely at the start of this year — that the Securities and Exchange Commission would propose a pilot program to measure the effects of maker-taker rebates on equity trade execution — is now quite possible as the year draws to a close, sources said.

"I said before, 'Not so fast, this (pilot) might not happen,'" said Richard Johnson, vice president, market structure and technology, at Greenwich Associates LLC, Stamford, Conn. "But then the tides kind of changed on me. There seem to be a lot of tailwinds in favor of this. … I think (the pilot) will go through."

Since the start of 2017, supporters of a maker-taker pilot include SEC Chairman Jay Clayton, who said in July the SEC would announce the plans for such a test, and the Treasury Department, which in a wide-ranging study of the capital markets released in early October called for a review of the maker-taker rebate model.

Also, David Swensen, chief investment officer of the $27 billion endowment at Yale University, New Haven, Conn., co-wrote a July 18 opinion article in the New York Times that blasted the maker-taker model, in which brokers and other market participants pay access fees to stock exchanges to take liquidity or receive access-fee rebates from exchanges for providing liquidity. Mr. Swensen called the rebates "kickbacks" to attract business to exchanges. And in Massachusetts, Secretary of the Commonwealth William Galvin in August said he was investigating whether brokers were routing stock orders based on maker-taker rebates instead of choosing the venue with the best price.

Such actions have highlighted the opposition among buy-side market participants — asset owners like Mr. Swensen as well as institutional money managers — to the maker-taker model, sources said. In a survey of 52 traders at money managers and institutional investors conducted from July to September by Greenwich Associates, 65% said rebates distort the equity markets and 62% said the SEC should institute a maker-taker pilot. This is possibly forcing the hand of the SEC into creating a pilot, sources said.

The SEC pilot most likely will be proposed before the end of this year, but with the required 60-day opening for public comments and industry preparations to conduct the pilot, it will be late 2018 before the pilot would be underway, they said.

"There are two elements at work, access fees and rebates," said Mehmet Kinak, vice president and head of global equity market structure and electronic trading at T. Rowe Price Group Inc., Baltimore. "Access fees create a conflict of interest in the market. Brokers are paid commissions and to try and mitigate their costs, they avoid the most expensive venues to trade. So, flows go to dark pools, which circumvents the high access fees of lit markets but may not get good quality executions. If you bring the access fees down, brokers are more apt to go for best execution and ... look at more lit venues."

Rebates create "a different dilemma," Mr. Kinak said. "Trading is one of the few areas where you can buy or sell something at the same price and come away with a profit, through the rebate from a venue for doing a transaction there. That rebate creates excessive remediation. There ends up being market participants out there that are just there to collect the rebate. Some people call them the 'grease' to smooth the market. But most of the time, they're in places where they aren't needed, like when you're trading in highly liquid stocks. If they provide liquidity in places where liquidity is needed, that's one thing. But in a highly liquid market, that's not the case."

The issue of maker-taker speaks to how all market participants look at trading and best execution, said Jason Valdez, managing director, head of equity sales and trading, at institutional broker-dealer Penserra Securities LLC, Chicago.

"I'd like to see maker-taker go away," Mr. Valdez said. "We've made it so that the exchanges could compete. But why can't exchanges compete on merit? That's what I have to do. If we could all just be better at our game, wouldn't that be enough? I think it's just noise. We'd see a lot less noise without maker-taker. I think it'd be healthy."

Mr. Valdez thinks the SEC should go beyond maker-taker and do a full review of Regulation National Market System — a move sources last January said was more likely than a maker-taker pilot but has not been discussed as a possibility by the SEC.

Ryan Larson, head of U.S. equity trading at RBC Global Asset Management (U.S.) Inc., Chicago, said he thinks the SEC's approach to creating a pilot is appropriate, as opposed to banning maker-taker in its current form.

"I don't think the deck is stacked against maker-taker," Mr. Larson said, "but to make any changes in the market, you need to prove whether something does or doesn't work. We need to underscore that this is a pilot. It would allow the SEC to collect the data and make an evidence-based decision."

Said Peter Maragos, CEO at Dash Financial Technologies, a New York-based trading technology and analytics provider: "I don't agree that there's an anti-rebate sentiment. There's a lot of rhetoric against rebates, but there's not perfect symmetry about the arguments. It's not a foregone conclusion that rebates are bad. (Mr.) Clayton has said in the past that liquidity's not free. A pilot would bear that out. Clearly the SEC is pro-pilot, but it's equally clear that the effect on liquidity is more in question.

"We have the most mature, sophisticated liquidity market on the globe," Mr. Maragos said. There's nothing wrong with providing incentives. Just changing the market structure doesn't change the issue. That will all come out in the comments on a pilot. This is a pretty big deal. If there's a pilot on something this big, there will be a lot of voices weighing in. The SEC has always sought to get participation in establishing a pilot."

Stock exchanges are against what they called an "ill-defined" pilot in a letter to Mr. Clayton Oct. 13.

"The exchanges' view is that U.S. investors have better access to markets and information, spreads are narrower, and other trading costs for average investors are lower than they have been before," said the letter from the New York Stock Exchange, Nasdaq Stock Market LLC and Cboe Exchange Inc. on behalf of its Bats exchanges. "Thus, the exchanges do not believe that a clear problem has been quantified."

RBC Global's Mr. Larson said the SEC's overall approach to market structure changes, including its earlier creation of an equity market structure committee and this month's announcement of a new fixed-income market structure committee, show the agency is moving "in a really good direction. But at some point, yes, there will be a pilot, absolutely. The SEC making evidence-based decisions is the way to go."

T. Rowe Price's Mr. Kinak said he thinks the SEC will create the pilot as a rule-making proposal, which would allow it to take into account public comments to determine the pilot's details. That would differ from how the SEC's current tick-size pilot to increase liquidity in small-cap stocks was created; Mr. Kinak said that pilot was done as an amendment to Regulation NMS, which allowed the exchanges to determine the structure of the pilot.

"The benefit of (the Reg NMS amendment) is that the pilot is implemented quickly, but the drawback is ... market participants have no input in how the pilot is structured or implemented," he said.

Mr. Maragos added, "I don't think there will be an NMS amendment. This is a much bigger undertaking (than the tick-size pilot). This affects the biggest names, the biggest markets out there."