Testimony Before the U.S. Senate Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs by Bradley Katsuyama, President and CEO, IEX Group, Inc.
Committee Ask: Address conflicts of interest affecting brokers charged with seeking best execution of customer orders, including conflicts posed by market rebates, access fees, and payments to retail brokers for customer order flow. Rebates and fees.
Katsuyama: The so called “maker/taker” (and the inverse “taker/maker”) model, where providers of liquidity are paid a rebate per share traded and takers of liquidity are charged a fee (or vice versa), with the market venue (i.e. exchange) keeping the difference, has increased venue competition since its emergence in the late 1990’s. The practice became nearly universal among U.S. equity exchanges by the time Regulation NMS was effected in 2007. The introduction of the rebate and the increased certainty of execution brought on by Regulation NMS has been a benefit to electronic market makers and created a competitive niche of trading strategies specifically focused on capturing the rebate. Intense competition for rebates among professional traders has reduced the likelihood of investor orders adding liquidity in maker/taker markets, either relegating those orders to the back of the exchange queue or requiring them to disproportionately take liquidity and therefore pay the access fee.
Today there are pricing models set at various price points for rebates and fees. The largest exchanges by market share pay high rebates and charge high take fees. These markets tend to have more competition to add liquidity, and therefore more interest at the inside price. These markets are also the most expensive markets on which to take liquidity (because they charge the highest fees), and at times may be avoided by a broker sensitive to its own economics, despite the market having the most liquidity at the inside price.
Committee Ask: Describe the role of high frequency trading in today’s marketplace and the relationship between benefits attributed to high frequency trading, such as increased liquidity and narrowing spreads, and the above conflicts of interest.
Katsuyama: Strategies that exist solely to exploit structural inefficiencies impose unnecessary cost and potential risk to the system…High frequency trading strategies were generally categorized by the SEC 2010 Concept Release on Equity Market Structure as: passive market making, arbitrage, directional, and structural. The first two of these provide the greatest social value to the market; liquidity provision, elimination of natural inefficiencies, promotion of price discovery and the intermediation of interest that would otherwise not interact.
The last category, structural strategies, are strategies that exist solely to exploit a structural inefficiency, or to the extent that any strategy of the prior categories are materially benefitting from structural inefficiencies, must be considered with the most discriminating examination. The Act requires the “removal of impediments to and perfection of the mechanism of a national market system”. Inefficiencies in the structure of the market; communication networks, trading and information systems, and market data dissemination, pose a particular risk to the integrity of the composite market place because the exploitation of such inefficiencies does not eliminate the inefficiency, and therefore the opportunity to extract value from the system is perpetual, as is not the case with other types of more natural inefficiency.
Read the entire testimony