Growing commoditization drove broker-dealers to embrace the maker-taker model nearly 20 years ago in a bid to differentiate and maintain margins, but the model's heyday may be coming to an end. A combination of both regulatory and market pressures promise to simplify the market, removing liquidity-based credits and fees in favor of more direct funding structures.
The Securities and Exchange Commission is promoting a controversial pilot program that would ban maker-taker rebates from the equities market in an attempt to ensure clients and customers can better determine the true value of a trade. At the same time, alternative trading systems such as IEX have decided to forego continually shifting fee schedules. Instead, they've adopted flat market access fees. Although equities markets are unlikely to completely abandon the maker-taker model, there is a growing space for broker-dealers and trading platforms that seek a less complex fee system.
The Rise of Complexity
Over the past two decades, equities markets have become a labyrinth of rules and guidelines, though not by design. Rather, intricate fee schedules and the maker-taker system itself are byproducts of the drive for differentiation by venues. Many broker-dealers struggled to claim a competitive advantage following the adoption of regulations such as the SEC's Order Handling Rules, which increased transparency for clients but threatened to commoditize broker-dealers and their services.
Soon after, the maker-taker model was born. Island ECN, which was one of the first electronic communication networks for stocks and was indirectly created by the Order Handling Rules, was the first to adopt the maker-taker model. Through this system, traders are encouraged to inject liquidity into the market through a combination of fees and credits. Despite its intricacies, the maker-taker model offered clear advantages to broker-dealers; after implementing the maker-taker model, Island's market share increased to nearly 13% in 1999 from 3% in 1997.
The Rebirth of Simplicity
Despite the advantages offered by the maker-taker model's rebate system, its ubiquity and high level of complexity have left many firms seeking an alternative. Still, efforts to move away from rebate-based trading systems will take time, especially given the number of firms whose margins depend on credits earned for creating liquidity (high-frequency traders in particular). Many broker-dealers will continue to rely on the maker-taker model to differentiate their organizations and support profit margins, giving them little incentive to embrace flat-fee exchanges or pared-down pricing structures.
Further, plenty of large firms have little incentive to move to simpler trading platforms. Mammoth financial services institutions like Morgan Stanley and Goldman Sachs have already invested heavily in powerful tools to track the true cost of their trades -- accounting for exchange fees and rebates as well as the asset price -- and so have little motivation to push toward a less elaborate system. These firms will likely take advantage of both flat-fee and maker-taker exchanges, but because of their immense resources, are unlikely to express a strong preference for simple pricing models in the near future.
Adapting to the New Normal
In all probability, over the next decade equity markets will support a small number of exchanges (or venues) with simplified fee structures as an exception to the rule, rather than the new normal. The maker-taker model still offers strong benefits, like greater liquidity and a smaller bid-ask spread, which more than offset its added complexity for many organizations. What's more, some possess the resources to mitigate their pain points with more complex fee structures.
For smaller broker-dealers, however, flat-fee exchanges likely will prove a welcome relief. Given the likelihood that the maker-taker model will continue to reign supreme for the time being, these smaller broker-dealers will need to invest in the tools and skills to navigate traditional exchange pricing models. Ultimately, simplicity is joining, not replacing, complexity.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.