Kickbacks, Conflicts and Darkness: Welcome to Your “Modern” Stock Market

New York Stock Exchange

New York Stock Exchange

By Pam Martens and Russ Martens: October 29, 2015 

Chances are pretty high that among the daily lexicon of most Americans, you are not going to hear the words “maker-taker.” And yet, outside of the debate about preventing Wall Street’s too-big-to-fail banks to create another epic taxpayer bailout in the future, the maker-taker debate is one of the hottest on Wall Street. On Tuesday of this week, the glacially-slow to respond Securities and Exchange Commission (SEC) held a full day hearing on the “maker-taker” model and other stock market structure dysfunctions.

In simple terms, maker-taker is another wealth extraction tool used by Wall Street firms to pick the public’s pocket in the name of stock market liquidity. In more complex terms, brokers servicing retail clients and institutions (like those managing your pension money) are incentivized to send their customers’ stock limit orders to trading venues that will pay them a rebate (on the premise that they are “making” liquidity) while traders who trade on those limit orders are charged a fee (on the premise they are “taking” liquidity). Thus the maker-taker model.

Finance Professor Larry Harris, of the USC Marshall School of Business, told the SEC panel on Tuesday that “fees charged to access standing limit orders are essentially kickbacks that exchanges charge people who want to trade with their clients who offer limit orders. In any other context, collecting such fees would constitute a felony. Although legal in the security markets, they are impediments to fair and orderly markets. They need to go away.”

Broker-dealers who process retail customer stock orders as an “agent” for the customer have a duty under the law to route stock orders to the venue which will provide best execution to their customer, not to the venue that will give the broker-dealer the biggest rebate. Professor Harris told the SEC panel that the maker-taker model undermines the agency role of broker-dealers, because “Customers whose standing limit orders were routed to maker-taker trading systems were worse off because their orders did not trade as quickly as they would have traded had they been posted at traditional exchanges.”

Tragically, most of the traditional stock exchanges, as well as most of the dark pools that proliferate across Wall Street, are today using the maker-taker model.

The maker-taker pricing model typically means a charge of $0.003 per share to take liquidity (30 cents per 100 shares) while paying a rebate of $0.002 per share to post limit orders (20 cents per 100 shares). The trading venue keeps the difference, or 10 cents per 100 shares. On billions of shares traded, that’s real money. And it’s not going back to the customer.

In a Spring 2014 paper published in the Virginia Law & Business Review, Stanislav Dolgopolov argued that the maker-taker model may also pose stock market manipulation issues. The title of the article is: “The Maker-Taker Pricing Model and Its Impact on the Securities Market Structure: A Can of Worms for Securities Fraud?” Dolgopolov writes:

“Aside from agency trading, which raises concerns about the duty of best execution, another relevant issue is market manipulation — chiefly in the context of principal trading. Of course, MTPM [Maker-Taker Pricing Model] influences a wide variety of trading strategies, given HFT’s [High Frequency Trading] razor-thin profit margins, and it is important to consider whether this financial innovation has created any trading strategies falling under market manipulation. One key impact of MTPM is the emergence of ‘rebate arbitrage’— also sometimes called ‘rebate harvesting’—aimed to generate profits primarily from collecting liquidity rebates… Furthermore, rebate arbitrage may be enhanced by the usage of rebate-oriented order types, such as ‘add liquidity only’ or ‘post only.’ ”

Despite multiple Congressional hearings since author Michael Lewis published his 2014 book Flash Boys, and went on 60 Minutes to state that the U.S. stock market is rigged, the SEC has done essentially nothing to correct these and many other abuses in today’s stock market structure. Traditional stock exchanges, that are supposed to be self-regulatory bodies, are still charging enormous fees to allow high-frequency trading firms to co-locate their computers next to the stock exchange computers to gain a speed advantage. The stock exchanges are still selling a faster direct feed of trade data to those who can afford the steep price.  Discount brokers are still selling their own customers’ stock orders to dark pools run by some of the biggest Wall Street banks in an unseemly system known as “payment for order flow,” a practice used by Bernie Madoff and which raises serious questions as to whether the broker is routing orders for best execution for the customer or greatest profit advantage to itself.

On June 17 of last year, prior to his retirement, Senator Carl Levin convened a hearing on the stock market’s structure. The title of the hearing was “Conflicts of Interest, Investor Loss of Confidence, and High Speed Trading in U.S. Markets.” Since that hearing, the market suffered another wipe-out of stock limit orders on August 24 when the Dow Jones Industrial Average plunged 1089 points in the first few minutes of trading, taking out limit orders at the lows on the day in many cases. The market then recovered much of those losses to close the day with a loss of 588 points on the Dow.

A similar wealth destruction occurred to the little guy on May 6, 2010, the date of the infamous “Flash Crash,” when the Dow plunged 998 points and then closed the day with a loss of just 348 points. In a speech on September 7, 2010 at the Economic Club of New York, Mary Schapiro, then SEC Chair, told the audience the following:

“A staggering total of more than $2 billion in individual investor stop loss orders is estimated to have been triggered during the half hour between 2:30 and 3 p.m. on May 6. As a hypothetical illustration, if each of those orders were executed at a very conservative estimate of 10 per cent less than the closing price, then those individual investors suffered losses of more than $200 million compared to the closing price on that day.”

What will it take for Congress and regulators to stop this serial fleecing of Americans by Wall Street?

Editor’s Note: Stanislav Dolgopolov, author of the article “The Maker-Taker Pricing Model and Its Impact on the Securities Market Structure: A Can of Worms for Securities Fraud?” referenced above, has kindly written us to clarify his views for our readers. He writes as follows:

“My conclusion was that rebate arbitrage (or at least its prevailing forms) is unlikely to constitute market manipulation. While rebate arbitrage may have little value and just boost volume, it typically does not fit the legal definition of market manipulation, which is quite narrow. The essence of market manipulation is in producing artificial price movements in order to profit from them, and rebate arbitrage actually works better in stable market conditions (i.e., essentially buying and selling at the same price and collecting rebates on both sides / riding one-tick movements but not necessarily causing them). That being said, I did note in the paper that ‘The inadequacy of disclosure for the expanding universe of order types has been noted specifically in connection with [the maker-taker pricing model]…’ and ‘If certain HFT trading strategies [shaped by maker-taker arrangements] are based on the discrepancy between the actual functioning of an order type and its formal documentation, using [the federal antifraud prohibition] should be an option.’ ”

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