What Michael Lewis Missed: The 'Maker-Taker Model' Has Outlived Its Usefulness

Includes: DIA, QQQ, SPY
by: Michael Pagano

The “maker-taker model” in U.S. equity markets has essentially outlived the purpose it was created for in the late 1990s.

The existence of maker-taker creates all kinds of distorted incentives for brokers and makes the market much more complex than it needs to be.

So, eliminating maker-taker, as well as creating a common, high-speed data-feed that is available to all market players, would make for a more competitive yet less fragile financial market.

In the past decade, more and more trading has vanished into dark pools and the rise of high frequency trading has emerged as the new big story in financial markets, putting investors in an uproar and federal regulators on the hunt for wrongdoing. But what many have missed is the law of unintended consequences when it comes to the regulation of financial marketplaces, particularly Regulation NMS. As water always seeks its level, so do sophisticated traders looking for an edge in executing their trades as quickly and anonymously as possible.

As the only finance academic (and also a former banker) on the Financial Industry Regulatory Authority, I have been part of the committee at FINRA wrestling with how to address the concerns of institutional and retail investors when it comes to HFT and dark pools.

My personal observation is that the "maker-taker model" has essentially outlived its purpose.(1) It was initially used by Electronic Computer Networks (ECNs) in the late 1990s to help pull order flow from the U.S. financial markets that was essentially a market dominated by the duopoly of NYSE and NASDAQ. At that time, most of the trading happened on those two markets, and "order flow attracts order flow" meant that investors were very reluctant to send their orders to new, untried, and less-liquid competing market structures such as Archipelago and Island. So, these upstarts used "maker-taker" to lure order flow to them, and in that way, were very successful in taking market share away from NASDAQ (at first) and then the NYSE.

They did this because the ECNs were cheaper and faster.

This initial success encouraged even more competitors into the U.S. equity market business, and thus the number of trading venues proliferated. HFT then really took root once the SEC introduced Regulation NMS in 2007 by allowing all markets to be electronically inter-connected and orders had to be routed to wherever the best price is, i.e., by establishing the "no trade-through" rule.

Now that markets are required to be inter-connected and HFTs and "smart order routers" ensure there are no easy arbitrage opportunities across venues, there is no need for a maker-taker system of rebates to help a new upstart gain market share. As we are seeing with the IEX (the heroes of Michael Lewis' "Flash Boys"), a new exchange can attract order flow without having to play the maker-taker game.

Yet the existence of maker-taker creates all kinds of distorted incentives for brokers, and makes the market much more complex than it needs to be. The markets have become like a "Rube Goldberg machine"; that is, a needlessly complicated machine that does a relatively simple task. Trading IBM (NYSE:IBM) stock should not be that difficult a thing to do but because of maker-taker, as well as proprietary high-speed data-feeds, colocation services, etc., the market has become incredibly complicated.

So, eliminating maker-taker (either via regulation or by market forces such as IEX), as well as creating a common, industry-wide high-speed data-feed that is available to all market players, would go a long way to simplifying the market system. In addition, the regulatory differences between regulating dark pools and lit markets need to be harmonized. The SEC seems to be moving in this general direction as they have recently proposed a pilot program to see how liquidity would be affected if some stocks were not traded within a maker-taker model.

The above actions not only make the market less complex, but also make it fairer and will probably lead to a shake-out where several market venues will go out of business. This is a good thing in that there will then be less markets for a broker to need to be connected to, which also reduces the likelihood of a system-wide failure. Thus, the markets can become less complex and less fragile while still remaining quite competitive -- all of which are big benefits to institutional and retailer investors alike.

(1) Maker-taker refers to the prevailing practice of market centers (e.g., BATS, Nasdaq, etc.) to pay a trader who places a limit order on the center's order book (i.e., the trader gets paid to "make" liquidity by placing a limit order). Conversely, the market center charges another trader a higher fee to "take" liquidity, which occurs when such a trader places a traditional market order. The difference between the lower make-fee the market center pays and the higher take-fee it collects is then kept by the market center as its profit (the numbers are less than a penny per share, usually less than 0.3 cents per share). So, in the current market structure, brokers can keep the make-fees generated by placing their customers' orders (rather than pass them on to the customers). Thus, the brokers have an incentive to send an order to the market center where the brokers get the highest make-fees (sometimes referred to as "rebates") even though this might not lead to the best execution of the client's order. This maker-taker model thus can distort where orders are placed and makes the whole system more complicated because each market center has a different set of make-take fees. In my opinion, it has added unneeded complexity to the market and the whole idea of maker-taker has outlived its original purpose of helping upstart competitors vs. the old duopoly of Nasdaq and NYSE.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.