Liquidity, Spreads, and Incentives: Are Rebates Needed for Illiquid Stocks?
It’s no secret that IEX believes that rebates — a form of payment for order flow — represent a conflict of interest and undermine the integrity of U.S. public equity markets.
But if you poll the rest of the industry, opinions on rebates typically splinter based on the liquidity of a stock: rebates are not necessary for very liquid stocks, but are essential for attracting liquidity in less liquid stocks.
Here is what the three big exchange operators have said about rebates:
“BATS does not believe that highly liquid securities require as great a rebate as less liquid securities”
- Source: BATS Open Letter (1/6/15)
“If you look at the average US stock, let’s say the top 500 or top 1,000, they trade very well and are very liquid. When you get to the ones below that, which is the vast majority, many of those stocks are illiquid. So how do you incentivize market makers to provide support? Rebates play a very important role in that.”
- Nelson Griggs, Nasdaq (Source: Business Insider 8/24/17)
“[E]xchange-paid quoting incentives are a necessary mechanism […] to support liquidity […]”
-Stacey Cunningham, NYSE (Source: Business Insider 7/25/17)
“Liquidity” is one of the many terms in our industry that is over-used and under-defined. But when we describe stocks as “liquid,” we’re generally referring to stocks with tightly-quoted spreads and a large amount of resting interest at the NBBO (National Best Bid and Offer).
Liquidity for these generally easy-to-trade stocks can be found in a myriad of venues: dark pools, wholesalers, single-dealer platforms, inverted venues and on maker-taker exchanges. Because liquidity is plentiful, competition to trade is stiff, and participants are often willing to post orders without the added incentive of a rebate. In fact, over 50% of the volume in these stocks occurs on venues that do not pay rebates to add liquidity (the majority of it off exchange) and in many cases, charge a fee to add liquidity. This is the type of stock that the industry broadly agrees doesn’t require a rebate to attract liquidity.
But what about illiquid stocks? Included in this camp are small-cap stocks which are deservedly attracting a lot of attention for their important role in capital formation.
Supporters of the status quo lean on the argument that rebates play a role in attracting liquidity for illiquid stocks, which is fundamentally oxymoronic: if rebates successfully attract liquidity, then why are the stocks still illiquid?
Rebate supporters’ next argument is typically that in the absence of rebates, spreads in these illiquid stocks would widen even more. That is, they successfully keep spreads narrower than they would be otherwise.
This doomsday scenario ignores how market makers make money.
Market makers make money both from the spread and from collecting rebates. And rebates comprise a very small percentage of their profits for illiquid stocks, relative to the spread they can capture.
Liquid stocks typically have narrow spreads, often 1 cent, the narrowest tick allowed by regulation. A market maker capturing both the spread and a full rebate on both sides of a trade in a 1-penny spread stock, earns 1 cent per share from spread-capture and 0.6 cents from rebate collection (i.e., 37.5% of their profits came from rebates).
Illiquid stocks often have wider spreads — greater than 1 cent. In a 5-cent spread for example, the market maker earns 5 cents from spread capture, but still only 0.6 cents from the rebate. Meaning in this case, only about 10% of profits came from rebates.
In other words: The wider the spread, the less relevant the rebate is to a market maker’s profit.
The argument that rebates are somehow more relevant in illiquid stocks, is, therefore, simply illogical.
The argument that spreads would widen dramatically in the absence of rebates also withers under logic: there is no valid reason for spreads to widen by more than 0.6 cents per share (i.e., the maximum rebate on both sides), which of course, is less than the minimum tick size of $0.01.
Rebates dramatically increase the complexity of the U.S. equity market and make the pursuit of best execution more convoluted than it needs to be. Rebates are the primary driver of fragmentation (it’s why NYSE, Nasdaq, and BATS operate 10 exchanges between them), they create the temptation for conflicted order routing behavior, they increase explicit costs for brokers and market makers as exchanges monetize this complexity, and most importantly, they raise trading costs for investors.
And yet the justification for rebates hinges on their small profit contribution in illiquid stocks to a market maker’s bottom line. Something doesn’t add up.
Rebate reform, of course, is not the only reform needed in U.S. equities. For example, we as an industry should also look at tick sizes. Rebates are effectively a tool to achieve sub-penny pricing. There is a tick-size pilot underway; those results should spur an informed debate on whether, or how, to introduce genuine sub-penny pricing that does not introduce a conflict to the marketplace.
However, waiting to tackle several issues simultaneously is counterproductive. Rebates are an issue that can be solved in the near-term; recent industry dialogue around this issue has been extremely encouraging, and the SEC plans for an Access Fee pilot are promising — providing there is a “no-rebate” bucket included in the pilot, which we believe will demonstrate that execution quality is better in the absence of rebates.
Pilot or not, we believe it is imperative to eliminate the distortive conflict of interest that rebates represent.
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