Abstract
Stock exchanges structure their trading fees to subsidize liquidity by offering “make” rebates for providing liquidity through limit orders and charging “take” fees for consuming liquidity via marketable orders, leading to debate regarding the impact of these fees on market quality. Using an experiment performed by NASDAQ, I employ difference-in-differences analysis and find that a decrease in take fee and make rebate levels on one exchange leads to greater absolute pricing error and larger variance of mispricing for the market as a whole, beyond that expected from widened bid-ask spreads. This occurs because bid-ask spreads widen and fewer informative trades are executed.
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Notes
Many traders, including retail and numerous institutional investors, do not have direct market access, but rather trade through a broker. This is an important point raised by Brolley and Malinova (2013) because, in practice, these traders have the bid and ask prices from the exchange passed on to them, but not the volume-based market access fee. They instead pay a flat fee. While this flat fee will also change in the long run, the authors show that in equilibrium, the higher flat fee does not offset the reduced bid-ask spread, and thus overall transaction costs reduce.
In fact, this is what NASDAQ hypothesizes in its Dec. 12, 2014 SEC filing (NASDAQ 2014).
Rather than make-take fees, brokers typically charge a flat trade fee to its customers, which include retail traders, as well as other institutional traders not structured as brokers with direct market access. While these flat fees may increase in the long run, Brolley and Malinova (2013) show that in equilibrium, the increased fee does not offset the narrowed bid-ask spread, therefore overall transaction costs reduce.
There were further alterations to the fee structure which included rebates for non-displayed liquidity, non-displayed midpoint liquidity, and several other obscure order types, but in general, the make-take fee structure was reduced by 25¢ per 100 shares. Also important to the validity of the results in this study, the net fee remained 1¢.
A differentiation between percentage and dollar bid-ask spreads is important because the make-take fees are “volume-based,” rather than “value-based,” which means the fees and rebates are assessed on a dollars-per-share basis, rather than a percent-of-value basis, therefore the fee structure will affect the bid-ask spreads, and ultimately the market efficiency, of low and high priced shares differentially.
For more information on the Kalman filter smoothing-estimation procedure, see chapter 13 of Hamilton (1994).
By estimating the Kalman filter anew for each stock-day using intraday data, I am able to allow for the parameters of the pricing process to change each day. This is critical as the NASDAQ pilot likely changes the pricing regime of the treated stocks. By estimating these parameters for each stock-day, I am able to quantify the changes in these parameters, as well as control for these parameters when measuring latent variables, such as mean absolute pricing error (MAPE).
Since pt is the log of the midpoint price, |st|, and therefore MAPE, are also measured in the same units.
Inverted “taker-maker” pricing structures are located on the NASDAQ Boston Exchange and Direct Edge EDGA Exchange. This pricing structure has been argued to be an alternative to dark pools since it is cheap (due to the rebate) to execute trades taking liquidity on these exchanges. This structure has also been promulgated as a hot bed for predatory high frequency traders who are essentially being charged a “make” fee by the exchange to have access to the information provided by these fee-sensitive traders.
I later document that the NASDAQ pilot also altered adverse selection costs. Therefore, market makers have incentive to both widen their bid-ask spreads on pilot stocks–to compensate themselves for the loss of rebates–and to narrow their bid-ask spreads–because they have less of a need to compensate themselves against informed traders. Due to the simultaneity of these effects, the widening effect of the pilot is likely understated by these results.
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Acknowledgements
I would like the thank Rick Harris, Pradeep Yadav, Seth Hoelscher, Leo Pugachev, Wayne Thomas, Tor-Erik Bakke, Scott Linn, Tom McInish, Pace Weng, Vivek Sharma, and Christine Jiang for their helpful comments and suggestions, as well as seminar participants at the University of Oklahoma, Missouri State University, University of Memphis, University of Massachusetts–Lowell, the Southwestern Finance Association, the Eastern Finance Association, and the Financial Management Association. All errors remain my own.
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Black, J.R. The impact of make-take fees on market efficiency. Rev Quant Finan Acc 58, 1015–1035 (2022). https://doi.org/10.1007/s11156-021-01016-w
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DOI: https://doi.org/10.1007/s11156-021-01016-w