Makers and Takers
High-frequency trading companies are often called makers. Their business models heavily depend on highly specialized trading strategies that capture payments. Large investment firms that buy and sell large blocks of stock or hedge funds that bet on the short-term price movements are often called takers.
Maker-taker models directly oppose traditional customer priority, where customer accounts have order priority and do not need to pay exchange transaction fees. Exchanges charge market-makers fees for transactions, and order flow payments are collected. This is called the customer priority model. Order flow payments are funneled to brokerage firms to attract customers to an exchange.
Maker Fees
Limiting orders placed on an exchange and not filled immediately adds liquidity to the order book. An exchange may pay a maker fee, less than the taker fee, to market participants who expand their order book. This is because they are incentivized to attract traders. A market maker might be charged a fee to place an order but could receive a transaction rebate to provide liquidity.
The maker fee will be charged if the trade order is not immediately matched against an opened order. To ensure that they receive the transaction from the maker's point of view, investors can post limit orders that are different from the current security price. However, the transaction settlement does not happen immediately, in exchange for a maker fee.
Taker Fees
Market orders are often executed immediately after they are placed. This order removes part of the security's existing liquidity. This is bad news for exchanges because the security's liquidity has declined. Exchanges charge taker fees to discourage trades from removing pending orders. The taker fee is typically higher than the maker fee. If the trade order is executed instantly and takes liquidity from the market, the taker fee will be paid. Traders might prefer to settle their orders immediately and will pay higher fees. A market order will allow the trader to execute their order immediately if this is the case.
An Added Incentive
The maker-taker model is a relic of 1997, when Joshua Levine, creator of Island Electronic Communications Network, created a pricing system to encourage providers to trade in markets that have narrow spreads. In this scenario, the maker would get a $0.002 per share rebate, and takers would pay $0.003 per share fees. The exchange would keep the difference. Incentives such as rebate capture became a standard feature of the market. Payments ranged from 20-30 cents per 100 shares traded. Two of these exchanges are listed below. The customer priority system is used by the International Securities Exchange Holdings, Inc. and the Cboe Options Exchange, both controlled by the same company, Cboe Holdings, Inc.
Possible Pricing Distortions
The practice is criticized by those who believe that rebates and other discounts distort the publicly available bid/offer prices. High-frequency traders may profit from rebates by selling and buying shares at the same prices to make a profit. This spread can mask the true price discovery of assets. Some argue that maker-taker payments can create false liquidity by attracting only rebate-seeking people who don't trade shares much.
Robert Jennings, an Indiana University finance professor, and Shane Corwin, a University of Notre Dame finance professor, studied stockbrokers who regularly route client orders to markets that offer the highest payments. The research revealed that order execution quality was affected by stockbrokers routing trades to maximize rebate benefits.
A Closer Regulatory Look
In January of 2014, Jeffrey Sprecher, the Chief Executive Officer of Intercontinental Exchange Group, Inc., the company that controls the New York Stock Exchange, requested that authorities examine the practices of rebate pricing. The capital market group of the Royal Bank of Canada sent a letter to the Securities and Exchange Commission (SEC), stating that maker-taker arrangements generate conflicts of interest and should be prohibited because of this fact. Following the public outrage, Senator Charles Schumer (D-New York) requested an investigation into the situation from the SEC.
Luis Aguilar, the former SEC Commissioner, announced in an October 2015 speech that the SEC was considering a pilot program to reduce maker-taker rebates. The pilot program would eliminate maker-taker fees for a limited number of stocks. It would also allow traders to compare their trading results with comparable stocks that retain the maker-taker system. The U.S. Court of Appeals ruled in 2020 that the study was beyond the authority of the SEC and struck down the pilot program.
