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Yale Study on IEX is "Flawed" - Exquam Blog

Traders Magazine Online News, July 20, 2017

David Weisberger

The NYT published an editorial written by Yale professors, that is a tissue of lies, misleading stats, and inflammatory rhetoric that starts with the idea that rebates are a “new” thing helping Wall Street “fleece” investors.   Clearly, they don’t want facts to get in the way of their story, but rebates are NOT NEW.  Rebates were pioneered in the 90s by the Island ECN and became the dominant market model for equities worldwide over a decade ago.  Rebates are primarily a tool for incentivizing liquidity and, in the US, to narrow the spread when 1 cent is too wide.  There are, roughly speaking, two users of rebates:

  • Market makers and prop traders, for whom they pose no conflicts of interest and are purely an incentive to provide liquidity.
  • Brokers, for whom they can pose a conflict of interest in the situation where the broker is acting as an agent. IF disclosed and analyzed or passed thru, however, the conflicts could be mitigated.

Before diving into the specifics of the article, it is important to start by pointing out that the overwhelming majority of NYT readers are retail investors that place orders as either liquidity taking (market or marketable limit) or displayed limit orders.  Most do not even have the ability to place a dark or midpoint order.  This is vital to understand, since they, like IEX, conflate statistics which are based on dark midpoint orders with those meant to evaluate either displayed or fully marketable orders.  With that as a preamble, lets dive in…

Their first claim is that brokers take “kickbacks” for routing orders to exchanges based on rebates.  My first response is to the word “kickback” which I have previously argued against:

Rebates, however, are not “kickbacks”, as Mr. Katsuyama states, since that implies that they are illicit and serve no economic function.  Rebates are used in many order-driven markets as an incentive for market makers to provide liquidity.  (The main exceptions, such as the futures markets, have wider statutory bid offer spreads in order to incentivize market makers.)  The rationale behind rebates is that placing displayed limit orders is equivalent to giving an option to the market to take your liquidity.  If the bid offer spread is not sufficient to pay for that option, then rebates are needed.    In the aggregate, market makers will state that the one cent tick size / spread is not sufficient to overcome the option value.  Whether or not this is completely accurate, it is important to be careful, as a mistake would impair the liquidity that issuers and investors need.     

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