The Securities and Exchange Commission is set to decide by Dec. 8 whether to approve a proposal by the Nasdaq Stock Market to permit sponsors of exchange-traded funds to pay broker-dealers for making a market in their securities. It will make a similar decision on a proposal by NYSE Arca by January 12.
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.
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.
Back in 1997, when FINRA puts its rule on the books, exchange-traded funds were rare. The regulator had common stocks in mind, not securities whose prices are derived from those of common stocks.
Of the two exchanges, Nasdaq has taken the greatest pains to craft a plan that would not violate the spirit of FINRA Rule 5250. Both exchange proposals require the ETF sponsor to pay the exchange, which will then pay the market maker. They do not permit the sponsor to pay the market maker directly.
But Nasdaq’s proposal’s goes one step further, requiring market makers to meet certain quoting and trading standards to receive payment.
In addition, those payments will be based on how often the market maker is quoting at or better than the national best bid or offer, how much size it is quoting at the NBBO and how many shares it trades.
Arca’s proposal, on the other hand, requires no more of the exchange’s lead market makers than it already asks of them. That aspect of Arca’s proposal has drawn criticism from some quarters.
Mutual fund firm Vanguard, for instance, opposes the Arca proposal. The asset manager told the SEC in a letter that Arca “should impose materially higher performance standards” on its lead market makers (LMMs).
The proposals strictly target ETF sponsors, but Nasdaq, at least, has indicated that such programs could benefit a broad swath of operating companies.
“The SEC should allow companies to pay for market quality,” Ed Knight, general counsel and executive vice president at Nasdaq OMX, testified before the Senate Committee on Banking last year. “This has worked in our Nordic markets.”
If its reaction to Nasdaq’s first proposal, submitted in 2011, is any indication, the SEC is not enthusiastic about expanding coverage to operating companies. The proposal was geared exclusively to ETF sponsors, but the wording was open-ended. In it, the exchange-which had recently won SEC approval for its BX Venture Market-noted that its program could benefit all companies, not just ETFs.
The SEC declined to even consider that version. Nasdaq subsequently tightened up the language so there could be no doubt the proposal was solely targeting ETFs.
Still, pressure on the SEC to permit operating companies to pay for market making lurks in the background. In July, a bill co-sponsored by Reps. Patrick McHenry, R, N.C., and Scott Garrett, R-N.J., known as the “Liquidity Enhancement for Small Companies Act,” was introduced in the House and is sitting in committee.
In Canada and Europe, the practice has been accepted for years. A study last year by academics of the practice on the Oslo Stock Exchange found it improved liquidity in the target stocks, Nasdaq informed the SEC.
On Canada’s TSX Venture Exchange, the practice is legal as long as the contract between the dealer and the issuer is done on a fee-for-service basis. It cannot be structured so as to encourage a market maker to achieve any volume or price targets.
Longtime Toronto Stock Exchange market makers Independent Trading Group recently entered into an arrangement with a TSX Venture company called Aldridge Minerals to quote its stock. For Independent Trading, this was just good business.
“We’re branching out,” Independent president Dave Houlding said. “We’re looking to establish relationships with Venture firms before they get to Toronto.”
