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June 1, 2012

NYSE Looks to Pay LMMs

By James Armstrong

Following a similar proposal by Nasdaq OMX, NYSE Euronext has unveiled a plan to allow market makers to get paid for providing liquidity in exchange-traded funds. If approved, the plan could reduce the number of funds without lead market makers (LMMs).

In April, NYSE asked the Securities and Exchange Commission to authorize a pilot program that would add incentives for firms that become LMMs. Under the proposal, issuers could pay an additional $10,000 to $40,000 per year to attract market makers. NYSE would then distribute those funds to the LMMs.

Bryan Johanson

Bryan Johanson, managing director for global index and exchange-traded products at NYSE Euronext, said firms have been reluctant about becoming LMMs due to the risks involved, and the exchange wanted to offer an additional incentive to attract market makers.

Until 2007, all exchangetraded products listed by NYSE had LMMs, which receive higher rebates from the exchange and pay lower fees in return for market-making obligations. In 2007, five of the 223 new funds listed by NYSE did not have LMMs. Today, 62 of the 1,395 exchange- traded products listed on NYSE's Arca exchange do not have LMMs.

The lack of LMMs can cause serious problems for lightly traded funds. Even though an ETF by its nature is as liquid as its underlying securities-since shares can always be created or redeemed using the underlying stocks- a fund with a low volume and a wide posted spread will tend to be shunned by investors.

A Financial Industry Regulatory Authority rule prohibits payments for market making, but NYSE argues that applies to securities of individual companies, not to exchangetraded products.

According to Johanson, the rule is aimed at preventing price manipulation, but that shouldn't be a problem with ETFs, which are transparent and can easily be arbitraged against underlying assets.

Damon Walvoord, director of index and ETF sales and trading at Susquehanna International, which acts as an LMM, said he is supportive of the proposal, though he noted the modest incentives were not likely to lead to a sea change in the industry.

Nasdaq has proposed that issuers on its exchange could pay $50,000 to $100,000 annually to fund payments to market makers. BATS Global Markets, which launched its first primary listing of an ETF earlier this year, already has its own plan in place to encourage market making.

In Walvoord's view, all these programs have their merits, and they will likely appeal to different firms in different ways. The important thing is that people are taking an interest in improving market making, he said.

"The exchanges and the marketplace at large are paying attention to this issue," Walvoord said. "I think what's game-changing is the fact that they're taking first steps in this direction."

Noah Hamman, founder and chief executive officer of the ETF issuer AdvisorShares, said he is in favor of any plan that will help tighten spreads.

Increasing incentives for market makers could be very helpful for actively managed ETFs like the ones offered by AdvisorShares. These funds tend to have lower trading volumes in comparison with index-based products.

"Our type of ETF isn't about the buying and selling and frequent use," Hamman said. "Volume isn't always there."

If market makers could be enticed to lower overall costs for investors, AdvisorShares would certainly participate, Hamman said.

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