Beginning of the end for rebates and maker taker ? Rhetoric of Massachusetts Inquiry Risks Dangerous Politicization of Rebates Traders Magazine Online News, August 29, 2017 David Weisberger The current U.S. equity market provides American companies a competitive advantage due to the liquidity that trades on our markets every day. In fact, the average stock trades more than double the percentage of its market cap in America, than the other G7 markets. This is a boon to American companies, translating directly into an advantage for raising money and acquisition strategies, which ultimately means both more jobs and retirement wealth for millions of Americans. Like what you see? Click here to sign up for Trader Magazine's weekly newsletter to get breaking news, exclusive features, the industry photo of the day and more. With that as a backdrop, the news that Massachusetts Secretary Galvin is basing an “inquiry” into firms routing practices based on a self-interested tissue of lies, is a scary proposition. According to the WSJ and FT articles, the investigation is based on a NYT OpEd, which was essentially an infomercial for IEX, a corporation valued in the hundreds of millions of dollars by their investors, who wants rebates banned in order to limit their competition. The editorial in question was written by Yale professors, whose Dean of Leadership (Jeffrey Sonnenfeld) has been a paid consultant (for cash and stock) for IEX and a current board member (with stock compensation), whose CEO conferences are sponsored by IEX for hundreds of thousands of dollars and whose institution is invested in IEX. (Note – these allegations of undisclosed conflicts of interest by Yale are unconfirmed, but were told to me by insiders that have credible access to the information.) More important, the OpEd was completely wrong in how it depicts rebates as “kickbacks,” as well as numerous other flaws I have previously pointed out, making it a poor foundation for a serious investigation. Rebates are a method for exchanges to attract more liquidity to be posted, and is particularly important in the U.S. market, where the tick size is one cent for all stocks, which often is insufficient for market makers to profitably provide liquidity. It is critical to understand that rebates pose absolutely no conflicts of interest to liquidity providers such as market-makers and trading firms. The only conflict of interests created by rebates is when agency brokers opt to pursue rebates to lower their cost of trading without disclosing that to their clients. Interestingly, the retail brokers the Secretary sent letters to, do disclose where they route their client’s orders via rule 606. Having studied this issue in depth a few years ago, while running a wholesale market maker, I can also say that the retail brokers we studied averaged fill rates well over 95% (compared to aggressive definitions of what could have been executed) on the retail orders they sent to exchanges and not to market makers. When one considers that the retail brokers we studied utilize the collected rebates to keep commissions low and provide services to their clients, we concluded their routing was likely in the best interests of their clients. In addition, since all these retail brokers disclose where they route those orders, clients are free to decide whether their broker’s choices are reasonable. (Note that I agree with the chorus of voices that express concern over institutional routing being potentially impacted by rebates. This, however, does not change the fact that rebates are an important incentive for market makers to provide liquidity.) Getting back to the topic of political posturing, the labeling of rebates as “kickbacks” reminds me of an episode of the Simpsons, where President Lisa Simpson needed to raise taxes, but called it a “temporary refund adjustment” to avoid the dreaded label of being called a tax. It would have worked, except for her brother Bart’s change of heart, since the creators of the Simpsons understand the power of rhetoric.In this case, using the politically charged, derogatory label of “kickback” to describe a well-disclosed (by the exchanges), legal and important incentive to attract liquidity, is just as misleading and dangerous. This rhetorical device is designed to harm competition and liquidity in the equity market and benefit IEX, by stifling competition for liquidity from the other exchanges. To put this in perspective, in WYNN, the presumptive first listing on IEX, IEX trails Nasdaq in quote quality substantially. In July for WYNN, according to tick data analyzed by MayStreet and ViableMkts, IEX was at the NBBO roughly 1/3rd as often as Nasdaq, and had an average spread over 5 times as wide! It is obvious that IEX needs this to change, and forcing Nasdaq to stop providing incentives to market makers is one possibility. Considering both the role of rebates in providing incentives for posting liquidity and the fact that only brokers acting in an agency capacity have potential conflicts of interest, the best approach to mitigating conflicts is improved disclosures. Unlike a ban of rebates or a series of enforcement actions designed to ban rebates, which could cripple equity market liquidity, improved disclosures will likely result in behavioral changes while empowering investors to make better decisions. In particular, while Rule 606 could be improved for retail investors also, the key is to expand the rule to cover all institutional routing, along with proper order categorization and sufficient statistics to enable clients and regulators to determine if brokers are acting in their client’s best interests. I have described this approach in detail in both comment letters and previous commentaries.