When the going gets tough, the tough slash prices.
In the case of the nation’s stock exchanges, that means increasing rebates. With volume slumping, exchange operators are pulling out all the stops to reel in the big trading firms.
Volume in the first half of the year averaged 7.5 billion shares per day, down 20 percent from the same period last year. In July, the trend continued, as average daily volume slipped to 7 billion shares.
It is the brokers who supply those shares, so the exchanges must adapt to their straitened circumstances. In effect, that has meant paying them more for less.
In the current malaise, the exchanges are introducing new rebate programs and sweetening the terms of existing programs. They are adding new rebate tiers, reducing volume thresholds and, simply, increasing rebates.
Since January, the major exchange operators-NYSE Euronext, Nasdaq OMX Group, BATS Global Markets and Direct Edge-have introduced seven new rebate programs and improved the terms of five older programs.
“The good news for the Street is that rate competition is as intense as ever,” said Bryan Harkins, chief operating officer at Direct Edge. “It’s helping to offset some of the market volume challenges.”
Consider the changes in July alone. In that month, NYSE Arca introduced a new “step-up” rebate program that rewards traders who post more in a given month than they did in June. At the same time, Direct Edge’s EDGX exchange reduced the threshold for its highest rebate from an average 38 million shares to 20 million shares per day. Also in July, Nasdaq permitted its members to consolidate the trading of their affiliates in order to reach higher rebate tiers. Finally, BATS Global Markets’ BZX exchange tiered its rebate for the first time ever.
The situation harkens back to the 2007-2008 period of the first rebate war. Then exchanges and ECNs jacked up their payments by as much as 50 percent to within a penny of their take rates. That, in turn, left them with razor-thin spreads and heavily reliant on market data fees.
Spreads are coming under pressure this year, as well. Despite the moves on the rebate front, the exchanges are mostly not increasing their take fees. That’s because most take rates are either at or bumping up against the federally mandated access fee cap of 30 cents per 100 shares.
By contrast, the top rebate at many of the exchanges has been moving steadily higher this year. At 34 cents per 100 shares, EDGX now has the highest. NYSE Arca is not too far behind, with a rebate of 32 cents for every 100 shares of displayed liquidity. For both exchanges, their highest rebates are greater than their highest take fees.
At the same time, tier thresholds are coming down. Before this year, to qualify for an exchange’s highest rebate, a broker had to post about 50 million shares per day, on average. Now, under one exchange program anyway, brokers can grab the brass ring with only 8 million or 9 million shares.
“Exchanges are trying to maximize their revenues,” said John Jacobs, chief operating officer at Lime Brokerage. “What does it mean to lower a tier threshold? It’s effectively a price cut. If they need to cut prices to attract more volume, then that’s what they will do.”
Bettering a rebate program’s terms, however, may not translate into sustained levels of higher volume, pros note. While the exchange with the better deal might experience a sudden influx of orders, the gusher could peter out. If traders don’t experience better fill rates at the newly cheaper venue, they may go back to where they came from.
“When a price change goes into effect, there may be an immediate blip as a result of brokers’ automated reweightings,” explained Shane Swanson, a partner and general counsel at Eladian Partners, a proprietary trading house. “But if that blip isn’t sustainable, because the liquidity profile isn’t as advantageous, the situation will change again.”
Also, most trading executives tell Traders Magazine the rebate is only one factor in their routing decisions, and typically not the most important one. Of greater importance is the “liquidity profile” of a venue. That is a measure of the quantity and quality of liquidity at a given market center. It considers fill ratios, adverse selection and the impact of high-frequency traders.
This is especially true for those brokers handling institutional orders. “The quality of the execution matters the most,” said Jamie Selway, a managing director at Investment Technology Group. “You want to maximize liquidity and accomplish a quality fill.” He added, however, that if two or more venues are offering the same fill quality, the better rebate will break the tie.
One size fits all
Until recently, most rebate programs offered by exchange operators were of the one-size-fits-all variety. They targeted anyone willing to post liquidity. The more the broker posted, the more it received.
There were exceptions, of course. Both BATS and Nasdaq have experimented with rewarding traders for quoting in size, for example. Also, the creation of taker-maker exchanges, whereby liquidity providers are charged and takers are rebated, was a significant departure from business as usual.
But the vast majority of the business is still done on maker-taker exchanges, and their programs have largely been plain vanilla. That began to change late last year as the exchanges began to supplement their standard pricing programs with new ones that targeted specific audiences or behaviors.
Most exchange rebate programs have been-and still are-geared toward market makers and high-frequency trading shops. These firms provide the public markets with the lion’s share of liquidity. Conventional institutional brokers typically take more liquidity than they add and thus are more concerned about access fees. In addition, most of these players say exchange pricing is of less concern than liquidity when routing their customers’ orders.
Now Nasdaq and Arca have launched new initiatives meant to appeal to traditional brokers. In November, Nasdaq launched its “Investor Support Program” to draw orders away from dark pools and wholesalers. NYSE Arca copied the program in June. Both schemes seek high-quality mom-and-pop flow and bar participation by high-frequency traders, or firms with high numbers of canceled orders.
Behind the moves are the concerns of two sets of exchange customers. Because of the downturn in volume, high-frequency traders, a core exchange constituency, are increasingly trading against the quotes of their own kind when they would prefer to interact with institutional and retail flow.
Also, institutional brokers are closely scrutinizing the quality of the liquidity with which their customers interact. These factors put pressure on the exchanges to diversify their liquidity beyond market-maker/HFT quotes.
“They are looking to add flow to their platforms that is not high-frequency in nature,” explained Pankil Patel, director of the U.S. trading desk for Credit Suisse’s Advanced Execution Services. “It is important for them to get a good mix of flow into their pools. These programs are a way to incentivize us by giving us attractive rates. They want us to centralize our liquidity or place more of it on their venues.”
Significantly, both Nasdaq’s and Arca’s programs offer better terms to the firms that qualify than do their standard programs. Firms get more rebate bucks for the same or fewer shares.
Under Nasdaq’s plan, a qualifying broker is paid two rebates: the exchange’s standard plus a small ISP rebate. To qualify for the ISP rebate, a member must add more liquidity in a given month than it did in the baseline month of August 2010. Its rebate is based on the number of additional shares posted.
Originally a one-tier program, Nasdaq expanded it this year, adding two more tiers. The exchange will now pay 3, 4 or 5 cents per 100 shares, depending on how much volume a firm adds over its baseline.
NYSE Arca’s program is similar to Nasdaq’s, but less convoluted. Rather than offering two rebates-a standard and a sweetener-Arca simply offers one. Traders get a 32-cent rebate-now Arca’s highest-if they post at least 35 million shares per day. They get 30 cents if they post between 10 million and 35 million shares.
The deal is better than Arca’s standard program. There, the highest rebate is only 30 cents and traders must post about 50 million shares per day (based on July 2011 volume levels) to qualify.
Neither exchange would say how successful their programs have been. But at the end of July, the amount of offboard trading was roughly where it stood when Nasdaq started its program nine months earlier. Nasdaq’s market share, however, has increased this year.
In May, Nasdaq tried another strategy to reel in retail and institutional brokers. Because these players are typically large takers-rather then providers-of liquidity, Nasdaq sought to reward them for their taking. Under the initiative, firms that take more than 0.65 percent of total consolidated volume and supply at least 2 million shares per day will get a 29-cent rebate on the displayed shares. Firms that take more than 0.45 percent of TCV and supply at least 2 million shares will get a 25-cent rebate.
The deal represents a considerable price cut for Nasdaq. Under its standard program, to get a 25-cent rebate, firms must post at least 20 million shares. To get its 29-cent rebate, firms must post 0.45 percent of TCV, or more than 30 million shares, based on July volume levels.
Credit Suisse’s Patel is generally pleased with the Nasdaq initiative. “It’s been a positive for our firm,” he said. “The take threshold is high, but it’s allowing us to get the higher rebate. In the past, under the traditional provider programs, we had trouble hitting the higher tiers.”
Part II will appear tomorrow
