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December 1, 2012

SEC Tackles Market Maker Payments

By Peter Chapman

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  • SEC Tackles Market Maker Payments

The Securities and Exchange Commission is set to decide by Dec. 8 whether to approve proposals by the Nasdaq Stock Market and NYSE Arca to permit sponsors of exchange-traded funds to pay broker-dealers for making a market in their securities.

The idea first surfaced more than a year ago, when Nasdaq proposed a Market Quality Program, and the SEC has been grappling with the concept ever since. Arca proposed its own Fixed Incentive Program in April, so in July the SEC decided to consider the two exchanges' proposals together.

Jim Burns

In early November, one SEC official publicly professed to still having difficulty reaching a decision.

"It's a thorny one," Jim Burns, a deputy director in the securities regulator's Division of Trading and Markets, said at an industry conference sponsored by the Investment Company Institute. "Those filings raise significant issues."

The following week, Nasdaq tweaked its proposal to comply with industry criticism.

That was taken as a sign that SEC approval might be imminent. A Nasdaq spokesperson declined to comment.

Nasdaq's original proposal would have benefited ETFs trading fewer than 5 million shares per day, on average. The SEC didn't like that, so Nasdaq reduced it to 2 million in its second proposal.

Still, that figure took into account 90 percent of Nasdaq's ETFs, Vanguard told the SEC. In November, Nasdaq cut that threshold again-this time to 1 million shares per day.

The programs' stated goals are to facilitate after-market support for smaller and less widely traded exchange-traded products. Arca's proposal, however, would benefit any of the approximately 1,400 exchange-traded products it lists, industry executives said to the SEC in comment letters.

Any decision to allow companies to pay market makers to trade their securities would violate long-standing industry practice in the U.S., as well as the Financial Industry Regulatory Authority's Rule 5250, implemented in 1997. Overriding that rule is the SEC's main concern, according to a filing by the regulator in July.

Regulators and industry officials have long harbored concerns over permitting issuers to pay for market making. The fear is that the dealer will manipulate a stock's price to create the illusion of interest in the security.

The concerns date back to at least 1973, when the SEC advised Monroe Securities not to charge an issuer to quote its stock. At the time, the SEC said such a move "would appear to be inadvisable" in light of federal securities laws.

Nasdaq and others argue, however, that barring a dealer from accepting payment to quote a stock is not the same as barring him from accepting payment to quote an ETF. A market maker would find it difficult to skew the price of an ETF for very long because it is based on an index, which is reset throughout the day, they contend.