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April 1, 2010

Maker-Taker Distorts Markets: Study Says

By Peter Chapman

The maker-taker model deployed by exchanges and ECNs benefits neither liquidity providers nor liquidity takers. Worst of all, it distorts stock prices.

That's the conclusion of a new study by a trio of academics, including two former chief economists at the Securities and Exchange Commission.

The maker-taker model has become the de facto standard for the U.S. cash equities market in recent years. It is making inroads into the equity options market, as well. Under the make-take regime, exchanges pay a rebate to liquidity providers and charge liquidity takers an access fee.

The academics argue that the rebate has helped narrow spreads, but that liquidity takers are no better off because they must pay access fees. By the same token, the rebate enriches liquidity providers, but not to the extent it compensates for the narrower spreads.

And while maker-taker has served to narrow quoted spreads, actual economic spreads have not changed, the study maintains, because the quoted spreads don't incorporate the access fees. Thus, stock prices are distorted.

"The make-or-take pricing model thus would appear to accomplish nothing besides reducing quoted spreads and thereby obfuscating true economic spreads," the study says.

Besides the obfuscation, those most harmed by the situation appear to be internalizing market makers, according to the study. They must be willing to trade at the tight spreads of the exchanges, but do not receive rebates. (They actually pay for order flow.) They do not charge access fees either.

The study was underwritten by Knight Capital Group.

Authors of the study include Larry Harris, a professor of finance and business economics at USC and a former chief economist at the SEC; James Angel, an associate professor at Georgetown University; and Chester Spatt, director at the Center for Financial Markets at Carnegie Mellon University, and also a former SEC chief economist.

To fix the problem, the trio recommends the SEC require brokers to pass through the rebates and access fees to their customers. Barring that, the SEC should eliminate access fees, the professors said.


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