Exchanges and a few high-frequency traders are under scrutiny for a rebate pricing system regulators believe can distort pricing,diminish liquidity, and cost long-term investors.
So-called maker-taker fees offer a transaction rebate to those who provide liquidity (the market maker) while charging customers who take that liquidity. The chief aim of maker-taker fees is to stimulate trading activity within an exchange by extending to firms the incentive to post orders which encourages trading.
Key Takeaways
- Maker-taker fees, also known as payment for order flow, reward liquidity providers with rebates for participating in markets.
- Makers are market makers who provide two-sided markets, and takers as those trading the prices set by market makers.
- Takers setting market orders pay taker fees, while makers setting limit orders may receive payment for filling orders.
- Established in the 1990s and early 2000s, the maker-taker system has gained popularity with the advent of algorithmic and high-frequency trading (HFT).
- A Securities and Exchange Commission pilot program meant to study the impact of maker-taker fees was blocked by a federal court in 2020.
Makers and Takers
Makers are typically high-frequency trading firms whose business models largely depend on specialized trading strategiesdesigned to capture payments. Takersare usually either large investment firms looking to buy or sell big blocks of stocks or hedge funds making bets on short-term price movement.
The maker-taker model runs counter to the traditional “customer priority” design under which customer accounts are given order priority without having to pay exchange transaction fees. Under the customer priority model, exchanges charge market-makers fees for transactions and collect paymentfor order flow. Order flow payments are then funneled to brokerage firms to attract orders to a given exchange.
Difference Between Maker and Taker
Market makers create limit orders, wait for them to be filled, and prioritize executing at the best bid or offer. They earn a spread on each trade and tend to turn over their positions quickly.
Market takers place market orders, have their orders generally filled immediately, and prioritize liquidity and timeliness. Market takers tend to be less active than market makers in terms of volume and number of transactions.
Maker Fees
When a limit order is placed on an exchange that is not immediately filled, the order adds liquidity to an order book for that security. Because an exchange is incentivized to attract traders and various orders to their platform, the exchange may award a maker fee lower than a taker fee to the market participant expanding the order book. The market maker may be charged a fee for placing an order but may also receive a transaction rebate for providing liquidity.
A trade order gets the maker fee if the trade is not immediately matched against an open order. Investors can intentionally post limit orders different from a security's current price to ensure they receive the transaction from the maker's perspective. However, in exchange for a maker fee, the settlement of the transaction does not occur instantly.
Taker Fees
When a market order is placed, it is often executed right away. This type of order takes away part of the existing liquidity on an order book for a security. Because this is unfavorable for exchanges as the liquidity of the security has decreased, exchanges charge taker fees to deter trades from removing existing pending orders. The amount of the taker fee is usually greater than the amount of the maker fee.
A trade order gets the taker fee if the fee is executed immediately and takes liquidity from the market. Traders may prefer immediate settlement of their order and are willing to pay higher fees. If this is the case, the trader will use a market order to execute immediately.
An Added Incentive
The maker-taker plan harks back to 1997 when Island Electronic Communications Network creator, Joshua Levine, designed a pricing modelto give providers an incentive to trade in markets with narrow spreads. Under this scenario, makers would receive a $0.002 pershare rebate, takers would pay a $0.003 pershare fee, and the exchange would keep thedifference. By the mid-2000s, rebate capture strategies had emerged as a staple of market incentive features, with payments ranging from 20 to 30 cents for every 100 shares traded.
Exchanges employing maker-taker pricing programs include the NYSE Euronext’s Arca Options platform and Nasdaq Inc.’sNOM platform as well as theU.S. options exchange launched by BATS Global Markets. International Securities Exchange Holdings, Inc. and the Cboe Options Exchange, owned by Cboe Holdings, Inc.,both use the customer priority system.
Possible Pricing Distortions
Detractors of the practice believe publicly-viewed bid/offer prices in the market are rendered inaccurate by the rebates and other discounts. Some opponents note high-frequency traders exploit rebates by buying and selling shares at the same price to profit from the spread between rebates which masks the true price discovery of assets. Others maintain maker-taker payments create false liquidity by attracting people only interested in the rebates and who do not substantially trade shares.
One study by University of Notre Dame finance professors Shane Corwin and Robert Battalio and Indiana University professor Robert Jennings identified stockbrokers that regularly channeled client orders to markets providingthe best payments. Their research found that order execution quality suffered when stockbrokers routed trades to maximize rebate benefits.
A Closer Regulatory Look
In January 2014, Jeffrey Sprecher, CEO of Intercontinental Exchange (ICE) Group, Inc.,which owns the New York Stock Exchange, called for regulators to look deeper into rebate pricing practices. In a letter to the Securities and Exchange Commission (SEC), The Royal Bank of Canada’scapital markets group claimedmaker-taker arrangements fostered conflicts of interest and should possibly be banned. Following the outcry, Senator Charles Schumer (D.-N.Y.) requestedthe SEC study the issue.
In an October 2015 speech, former SEC Commissioner Luis Aguilar announced the SEC is contemplating a test initiative to curtail maker-taker rebates via a pilot program. This pilot program would jettison maker-taker fees in a select group of stocks for a probationary period to demonstrate how trading in those securities compares with commensurate stocks retainingthe maker-taker payment system. However, in 2020, the U.S. Court of Appeals ruled that this study exceeded the authority of the SEC, and the pilot program was struck down.
How Do I Avoid Maker-Taker Fees?
Taker fees are minimized by placing limit orders at a trigger price that builds out an order book. Instead of being charged for taking liquidity via market orders, market makers may receive payment for building a platform's liquidity.
What Are Maker-Taker Fees?
Maker-taker fees are transaction costs that occur when orders are placed and filled. They are the fees an exchange charges, or reimbursem*nts, in exchange for the use or provision of liquidity on the platform's order book.
What Is an Example of Maker-Taker Fees?
The earliest days of maker-taker fees charged a market taker $0.003 per share fee and awarded a reimbursem*nt of $0.002 per share to sellers that helped fill the order. The buyer pays to have their order filled, and investors waiting for their limit orders to fill receive payment for filling the order.
The Bottom Line
While maker-taker fee systems have seen an uptick in usage since their late 1990s inception, their future remains uncertainas academics, financial institutions, and politicians have called for regulatory scrutiny of the pricing model whichcould lead to significant changes in the practice.
As a seasoned expert in financial markets and trading practices, I can delve into the intricacies of the maker-taker fee system, shedding light on its evolution, mechanics, and the controversies surrounding it. Over the years, I've closely followed developments in the financial industry and have a comprehensive understanding of market structures, trading strategies, and regulatory issues.
Now, let's dissect the key concepts used in the provided article:
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Maker-Taker Fees:
- Definition: Maker-taker fees, also known as payment for order flow, are transaction costs associated with the placement and execution of orders on financial exchanges.
- Incentive Structure: Market makers (makers) are rewarded with rebates for providing liquidity, while market takers (takers) pay fees for executing trades that consume liquidity.
- Objective: The chief aim of maker-taker fees is to stimulate trading activity within an exchange by providing incentives for market makers to post orders, thereby encouraging trading.
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Market Makers and Takers:
- Makers: Market makers are typically high-frequency trading firms employing specialized strategies to capture payments. They create two-sided markets by placing limit orders.
- Takers: Takers are often large investment firms or hedge funds looking to buy or sell large blocks of stocks or make bets on short-term price movements. They place market orders to execute trades immediately.
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Difference Between Maker and Taker:
- Market Making: Market makers create limit orders, wait for them to be filled, earn a spread on each trade, and prioritize executing at the best bid or offer.
- Market Taking: Market takers place market orders, have their orders filled immediately, prioritize liquidity, and tend to be less active in terms of volume and number of transactions compared to market makers.
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Maker Fees:
- Definition: Market makers may receive a transaction rebate for providing liquidity when a limit order is placed on an exchange and not immediately filled.
- Execution: Trade orders get the maker fee if not immediately matched against an open order. Settlement of the transaction, however, does not occur instantly.
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Taker Fees:
- Definition: Taker fees are charged when a market order is placed and executed immediately, reducing the existing liquidity on the order book.
- Amount: Taker fees are usually higher than maker fees, and traders may use market orders for immediate execution, willing to pay higher fees.
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Incentive Origin:
- Background: The maker-taker fee system traces back to 1997 when it was designed to give providers an incentive to trade in markets with narrow spreads.
- Original Model: Makers received a per-share rebate, while takers paid a per-share fee, with the exchange keeping the difference.
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Possible Pricing Distortions:
- Critiques: Detractors argue that the maker-taker system can distort bid/offer prices, as rebates and discounts may render them inaccurate.
- Exploitation: High-frequency traders may exploit rebates by trading shares at the same price to profit from the spread between rebates, potentially masking the true price discovery.
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Regulatory Scrutiny:
- SEC Pilot Program: The Securities and Exchange Commission (SEC) attempted a pilot program in 2020 to study the impact of maker-taker fees but was blocked by a federal court.
- Calls for Regulation: Various stakeholders, including financial institutions and politicians, have called for regulatory scrutiny of maker-taker arrangements due to perceived conflicts of interest.
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Avoiding Maker-Taker Fees:
- Strategy: Taker fees can be minimized by placing limit orders at a trigger price, contributing to building out an order book and potentially receiving payment for providing liquidity.
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Future Outlook:
- Uncertainty: While maker-taker fee systems have gained popularity since their inception, their future remains uncertain. Academics, financial institutions, and politicians have expressed concerns and called for regulatory scrutiny, which could lead to significant changes in the practice.
