6.7.1 The measure and its purpose
Maker-taker pricing refers to a fee structure in electronic markets whereby providers of liquidity via limit order submissions (or ‘makers’) receive a rebate on their executed orders while active traders (or ‘takers’) pay a fee for executing against these limit orders. The current fee structure at the LSE (and many other European exchanges) uses maker-taker pricing and features both a quantity discount and a rebate for suppliers of liquidity.
The issues with maker-taker pricing are twofold. First, does this pricing scheme incentivise high frequency traders to dominate the provision of liquidity and exclude other traders from posting limit orders? Second, does it raises agency issues for brokers who route orders based on the net fees and who may as a result not provide best execution for their clients?
The policy issue is whether to limit maker-taker pricing with the stated objectives of reducing the role of HFT in markets and making order-routing decisions more transparent.
6.7.2 Benefits
In electronic markets, liquidity is provided by limit orders that are posted by passive traders willing to provide an option to active traders. The more limit orders posted on a market, the more liquidity there is for other traders to execute against. If there are no frictions in the market, then the bid- ask spread would settle at a level that exactly compensates the providers of liquidity with the value received by takers of liquidity (see Foucault (EIA12)).
Real markets do have frictions, however, so fee and pricing models are not irrelevant. By paying those who make liquidity while charging those who take liquidity, maker-taker pricing has the potential to improve the allocation of the economic benefits of liquidity production. This in turn can incentivise potential suppliers of liquidity and lead to faster replenishment of the limit order book. Varying maker- taker fees with market conditions also provides a means to improve liquidity provision during times of market stress. A recommendation to have such time-varying fee structures was one finding of the Commodity Futures Trading Commision (CFTC)-SEC’s Task Force On Emerging Market Issues (the Flash Crash commission).
Maker-taker pricing can also be an effective way for new market venues to compete against established venues. Smart order-routing systems can direct order flow to venues with more aggressive pricing models. That can in turn put pressure on fees in other markets and lead to more competitive pricing. The success of BATS in the USA is often attributed to their aggressive use of maker-taker pricing. An interesting competitive development in the USA has been the arrival of trading venues offering ‘taker- maker’ pricing. In these venues, providers of active order flow get rebates while providers of passive order flow face charges. Venues offering this pricing model are attempting to attract the ‘less toxic’ orders of retail traders, and market makers pay for the privilege of interacting with this order flow. In US options markets, both models exist simultaneously, suggesting that a variety of pricing models may be viable in heterogeneous markets35 .
6.7.3 Costs and risks
High frequency traders are generally better able to put their limit orders at the top of the queue due to their speed advantage and to their use of ‘big data’ to forecast market movements. The maker-taker fee structure may incentivise them to do so even more, with the result that institutional investors’ limit orders are executed only if high frequency traders find it uneconomical to do so. It follows that institutional investors will hold back from submitting limit orders, leaving the market vulnerable to
transient participation by high frequency traders during times of market stress. This, in turn, could exacerbate episodes of periodic illiquidity.
It also follows that because institutional investors will now submit more market orders, they will face increased costs arising from bid-ask spreads, and taker fees. This problem of higher trading costs can be compounded if the routing decisions taken by intermediaries on behalf of clients are influenced in a suboptimal way by the fee structure offered by disparate venues. In particular, the broker may opt to send orders to venues offering suboptimal execution in return for rebates that are not passed on to the originating investor. This incentive will be even greater if these rebates are volume-dependent. Because European best execution requirements are complex, it may not be easy to monitor such practices.
A complex system of maker-taker pricing that is context- and venue-dependent can confuse market participants and lead to erroneous decisions. This may be particularly true if markets vary fees and rebates across time. Because spreads can vary, it is not entirely clear how much incremental effect on liquidity will arise from time-varying rebates.
6.7.4 Evidence
There is little evidence in the academic literature that high frequency traders are ‘abusing’ the current fee structure. Hendershott and Riordan (2011) find evidence that high frequency market makers lose money in the absence of rebates36. This is consistent with competitive pricing strategies forcing spreads to lower levels than they would be in the absence of maker-taker pricing.
Examining the effects of a controlled experiment on maker-taker pricing on the Toronto Stock Exchange, Malinova and Park (2011) find that the bid-ask spread adjusted to reflect the breakdown of maker-taker fees37. They also found that the quoted depth of stocks eligible for maker-taker pricing increased significantly, suggesting provision of greater liquidity. Adjusting for the fees, the average bid- ask spread was the same before and after the introduction of maker-taker pricing, and volume was greater for those stocks. Overall, maker-taker fees improve markets by increasing depth and volume while holding spreads (including fees) the same. Anand et al. (2011) compares the make-take structure with the traditional structure in options markets, where exchanges charge market makers and use payments for order flow. They find that neither structure dominates on all dimensions but that the make-take structure is more likely to narrow existing quotes, attracts more informed order flow, draws new liquidity suppliers, and performs better in lower tick size options.
A similar study investigated the introduction of maker-taker exchange fees for Australian securities cross-listed on the New Zealand Stock Exchange in 2008. Berkman et al. (2011)38 found that depth at the best quotes as well as trading activity increases with the introduction of maker-taker fees, though there is little evidence of a change in bid-ask spreads.
The only study focusing specifically on maker-taker pricing in European markets identified by the Project is Lutat (2010)39. He finds that the introduction of maker-taker pricing by the SWX Europe Exchange did not affect spreads but led to an increase in the number of orders at the top of the book. Incidentally, Menkveld (2012) finds that spreads fell dramatically when Chi-X began trading Dutch index stocks, suggesting that its maker-taker model may have improved market competitiveness40.
6.7.5 Conclusion
Overall, the limited evidence suggests that maker-taker pricing improves depth and trading volume without negatively affecting spreads.
36 Hendershott & Riordan (2011). 37 Malinova & Park (2011).
38 Berkman et al. (2011).
39 Lutat (2010). 40 Menkveld (2012).