[To learn more about the impact of incentives and exchange pricing structures on best execution, please contact TABB Group for details on our latest research, “Rebates and Market Distortions: The Cost of Liquidity?”]
Our markets are not distortion-free. Liquidity and its immediacy have a price and a value. This price and value is harvested through a series of payment channels, including exchange pricing and tiers, retail payment for order flow, and soft-dollar payments between clients and brokers. Each of these payment channels bundles/trades off execution commissions for some value (market share, cash, or research). The question is: Do these tradeoffs impact execution quality? In some cases, researchers have clearly stated “yes”; in other cases, the answers are more nuanced.
Where investors can understand these trade-offs and easily apply pressure on their agents to improve execution, these conflicts can be managed simply through good management, focus, analytics and the reapportioning of order flow. To the extent that order flow is not easily portable, then we need to ask ourselves: Is execution quality suffering, and is the tradeoff between execution quality and these payments appropriate? If not, when is the right time for regulators to step in?
Clearly, understanding all of the various perverse incentives and value propositions is difficult, and harvesting/leveraging them can be incredibly complex and expensive. But just because things are complex and expensive, do they need to be banned or artificially “simplified” by regulators? What would simplification look like? If we banned maker-taker, would we also need to ban exchange pricing tiers, payment for order flow, and soft dollars as well? And even if we did ban these practices, would they make the market fairer, less volatile, less electronic or less risky? Or just simpler?
[Related: “Take the Time to Understand the Complexities of the Markets”]
Incentive programs, while complex, benefit many. Eliminating maker-taker runs the risk of reducing exchange competition while eliminating the incentive for providing liquidity. With the loss of liquidity, wider spreads and lower volumes are likely, and off-exchange trading likely would drop as the declining cost of taking liquidity changes the internalization incentives.
The question is: Should simplifying complexity for complexity’s sake be our goal, especially since most of this complexity is abstracted away by fast computers, smart order routers, and high-speed networking? While TABB Group is a proponent of simplicity, the industry’s and regulators’ target shouldn’t be simplicity alone; it should be a market that enables efficient, effective and trustworthy re-allocation of capital in a measurable way. The goal should be not just be fairness, but an easy way to measure, understand, and quantify execution quality and any tradeoffs. If the tradeoffs do not benefit you, your firm and your clients, then change should be just a click away.