(Editors note – due to the length of this response, I have pre-empted todays quick responses to several other articles and will include those in future posts)
Today, 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.
Interestingly, they are probably correct about the fact that some agency brokers post orders motivated too much by the potential for collecting a rebate in some cases. That, however, is a far cry from claiming that all rebates are kickbacks and all who earn them are receiving “ill gotten gains.” Even though rebates are well known, have existed in most global markets for over a decade, have a valid purpose in incentivizing liquidity, and only create a problem for investors if they are undisclosed, they claim that they are “another way in which the system is rigged.” The only kernel of truth in this is that there IS a need for better disclosure of rebates, and the execution quality of all routed orders. I have commented on this many times, including last week when I discussed this within the context of the proposed maker-taker pilot:
The chairman correctly identified that rebates are an incentive to provide liquidity, and that can be measured by current available data. However, the main reason for the pilot is to study how to “fix” the conflicts of interest faced by agency routing firms created by rebates and fee differentials. Routing firms, you see, sometimes route to minimize costs (for aggressive orders) or earn rebates (for passive routing), instead of maximizing fill probability for their clients, which is what “best execution” would require. Without reforming Rule 606 to require routing firms to disclose their execution quality stats AND fees/rebates for each type of order sent, however, it will not be possible to measure the impact of the pilot on routing behavior. Not only does today’s routing disclosure OR the SECs recent proposal fail to do so, but most TCA vendors don’t either, as they look only at executions and ignore un-executed orders! Simply put, the precise behaviors that the pilot purports to measure are not disclosed to the public, nor to most professional investors!
Their next point is to claim that investors should evaluate individual queue lengths when determining where to post and that, it is wrong to post on a large queue. This is, quite literally, completely wrong! It is like saying that it is a bad idea to post an item for sale on eBay, because they post hundreds of similar items, and recommending sellers to only post their item on a less trafficked site since theirs will be the only item of the same kind. Once again, I have written on the specifics of this claim as it relates to IEX:
Well-constructed SORs look at the consolidated queue across all markets when making routing decisions and evaluates certainty of execution, market impact and costs of each potential combination of options. The SOR must also consider the specific scenario (e.g. is the market moving fast, is the order smaller or larger than the consolidated queue? is the client cost sensitive? etc.) Considering this, the question that needs to be answered is if IEX, by virtue of having smaller queue sizes, has a higher certainty of execution and I would suggest that is unlikely for three reasons.
First, larger venue queues create more certainty of execution. Many routing decisions are for order sizes smaller than the consolidated queue, and, in that case, when one venue has sufficient quantity to fill the entire order, routers often send the full order to that venue to increase fill certainty. In situations where an order needs to be routed to multiple exchanges, the lack of a fill could be extremely costly, making the certainty of the larger liquidity queues attractive. Second, while IEX is cheaper than the large maker-taker exchanges that have more posted liquidity, they are more expensive than the BX, BatsY and EDGA exchanges, which leaves them in an undesirable middle position when costs are evaluated. Third, the speedbump decreases the certainty of fill, since it makes IEX’s quote slightly less reliable at any point in time. This was explained well by Larry Tabb in his recent post.
The NYT article next, takes a sharp left turn, and argues that recent execution quality data by Bats, means that investors should post orders on IEX. This is absurd for multiple reasons, but primarily because the only data relevant when deciding where to post orders is fill rate or “markout” data that is exclusive to displayed, posted orders and Bats did not even consider such orders in the cited analysis. That analysis is supposed to measure which exchange to route aggressive orders to, but, even then, there are multiple issues as I pointed out yesterday, by looking at specific data in May for Apple securities, which Bats cited in their analysis:
For AAPL for the entire month of May, according to data provided by May Street, IEX only set either the National Best Bid or National Best Offer roughly 0.17%. That is not a typo. IEX created the best bid or best offer less than all other exchanges (excluding Chicago, which never set the best price), and by over 2 full orders of magnitude less than either Nasdaq or the Bats group of exchanges. In addition, IEX was only AT the NBBO 5.6% of the time in AAPL, which compares to 92% of the time at Nasdaq, 87% of the time at BATS and 86% of the time at ARCA. So, while it is true that “effective spreads” are lower at IEX, that is the direct result of people sending orders to them “blind”, and, in particular, from orders sent to them probing for midpoint fills (as compared to orders that are willing to cross the spread). The data makes this extremely clear.
According to data from BestXStats, in May, for ALL Marketable orders, IEX had an effective/quoted spread of 127.5 which compares poorly to all the other exchanges, notably ARCA at 89.7, Bats at 94.9, and Nasdaq at 106.6. Of course, the reason for this is that they executed more shares away (via their router) than they did on their own exchange, which is the opposite of the other exchanges. To reconcile these numbers with the Bats website, however, the difference is that IEX executed a much higher % of AAPL shares as a result of “inside the spread” orders according to 605 data. In fact, IEX executed 48.6% of their AAPL shares from these orders, compared to just 6.29% from Bats and 4.38% from ARCA. This points to an clear conclusion: If one is instructing a SOR to probe at the midpoint, IEX is a worthwhile destination, compared to other exchanges. If, however, one wants to trade aggressively or take liquidity from displayed quotes (which is what exchanges are built to do), then IEX, based on data, is an inferior destination…
(I had previously done a similar analysis which shows that these results are reflective of the broader market as well)
The article concludes by implying that eliminating “kickbacks” would “elevate the integrity of the market”, and presumably help IEX’s market share. I actually agree that eliminating rebates would help IEX, since it would bring the rest of the markets down to their level of refusing to provide incentives for liquidity, but that is not a good idea for public policy. The real problem here is that populist rhetoric, whether it be in the NYT, from Yale professors whose endowment has an investment in IEX, or from Congress, risks hurting the competitiveness of America’s equity market. Today, the U.S. markets are the most liquid in the world, trading over double the percentage of market capitalization of listed companies as the rest of the G7 markets. This increased liquidity directly translates into lower costs for investors and for companies raising capital, so it is crucial that we not risk damaging the market with ill-conceived regulation.
The NYT and others who point out conflicts of interest, do have a point, however. That point would best be addressed by improving order routing disclosures, so that investors can see how where each type of order is routed, what rebates or fees were collected/paid, AND what the execution quality statistics were for each destination. That is a much better way to address the conflict issue than eliminating all direct monetary incentives for providing liquidity.