Sunday, 9 August 2015

Trading rebates - a choice, not an evil

There is often an outcry against offering trade fee discounts to market-makers. Some pundits call rebates, or negative fees, evil. That is naive. It's just a choice that has arguable rationale.
Dante's Lucifer contemplating why he is being blamed for trading rebates.

(scan of engraving by Gustave Doré illustrating Canto XXXIV of
Divine Comedy, Inferno, by Dante Alighieri.
Caption: Lucifer, King of Hell, 1861-1868)

I've been sufficiently annoyed motivated to meander through Fees-101 so I can point people to this post rather than engaging in a tiresome debate. This post is definitely not worth reading for a market professional.

Let's start at the beginning. Placing a limit order to buy at the bid is passive. You have to wait till you're hit. Passive orders, aka posting liquidity, and aggressive orders, aka crossing the spread, are different. When you use an aggressive order, that is, cross the spread, you are getting a worse price than the mid-point as a trade-off for the immediacy.

A passive order sits in the book as posted liquidity on the favourable side of the mid-market indication. However, there is a great danger in a passive order than you get traded through and you're immediately showing a loss on the execution.

You are taking a risk by posting liquidity.

The benefit to taking this risk of posting of liquidity is that you have the potential to be on the good side of the value of the product. You do have a prospect of also getting on the other side of the mid point to "earn the spread," if that's want you want.

Posting liquidity is inherently riskier than taking it. Posting liquidity may lead to a better price some of the time. It is a statistical game of thrones.

A passive order is a market microstructure option. I like to call it a micro-option. When you post liquidity, the benefit is the nett spread you average, or the nett price improvement relative to crossing the spread you gain. That benefit has to be considered nett of fees. This gain is the premium you hope to earn for the risk of the trade going badly against you.

This is the holistic view.

Now, many markets have the same fee for posting and taking liquidity. The extra risk of the micro-option is worthwhile if you have a net gain in price for your trade benefit. Fierce competition usually keeps such things in fine balance.

For a market-place, posting liquidity is useful. Not everyone wants to trade in a market without prices. Plenty of liquidity at best, and a depth of liquidity makes for a healthy market. Trading by appointment is not so efficient.

For an exchange to encourage liquidity there are many things they could do. One thing they can do is make order types to suit posting liquidity to make passive orders "safer" or advantageous. That quickly gets out of hand and we end up with today's crazy proliferation of order types. Anyone for a discretionary peg order with a double twist, pike, and unverifiable proprietary conditions? The history of order types is simply: good intentions gone bad.

"The evil that is in the world almost always comes of ignorance, and good intentions may do as much harm as malevolence if they lack understanding." (Albert Camus)

Another approach is to differentiate on transaction cost pricing. You can make passive orders cheaper. Furthermore, you can make passive orders cheaper but only if Mr Passive gives commitments or guarantees to post liquidity. Do that and you end up with market-maker programmes, such as being a Designated Market-Maker.

Making passive orders cheaper is simply a choice. Giving them a negative cost is just sliding the rule further down that scale and is not inherently evil. It is just a choice to encourage liquidity.

It can be very difficult to grow markets. It took CME FX futures over 30 years to get decent liquidity after their inception in the early 1970s. That is a long time and not necessarily related to their fees. It does emphasise that forming useful market-places can be hard.

You could also make an argument for higher fees for posting liquidity if the marketplace is trying to attract customers who prefer taking liquidity. If the net spreads or passive pricing gains remain "good enough", liquidity will still be posted. Some companies, such as BATS, have experimented with such differentiation in pricing for posting liquidity in alternate market places. Competition is tough.

For an asset manager, being traded through on a passive order is not the real problem it is for a market maker. An asset manager wants the inventory after all. FOMO is the real risk for them. Your order may not get filled at all as you're trading immediacy for potential price gain which turns into a worse execution if you miss out. Compared to a market-maker, passivity is a dissimilar, but nevertheless real, risk for an asset manager.


Posting liquidity is a micro-option. A potential gain in pricing for a passive order is offset against:
  • the risk of trading through and being immediately underwater on value; or, 
  • missing out and needing to chase which requires a worse price to complete. 
Fee alterations for passivity can make sense to encourage different behaviours and customer types. Rebates are not inherently evil, nor required, they just offset the inherent risks.  Growing market-places is a balance of many concerns. Fee differentiation is just one of those many concerns with no inherently "right" answer.

Rebates are not evil.

Happy trading,


PS: Going beyond stating the obvious above, this is an earlier book on market microstructure by Maureen O'Hara that sits on my bookshelf here. If you want to dig further, it is a good place to start. The book is still relevant and worthwhile, though a little dated. There is nothing in it on board accountability.

1 comment:

  1. Most people who complain about liquidity rebates ignore the inverted exchanges (fee for making, rebate for taking). As I see it, make/take fees on either regular or inverted exchanges are simply allowing for greater granularity in the pricing.
    On a traditional make/take exchange where rebates/fees are roughly 30 mils, if a stock is 4.50-4.51, the net price is really 4.497-4.513. If you had the same bid/ask on an inverted exchange, where make fees/take rebates were also 30 mils, the net price is really 4.503-4.507.
    As an HFT, if I'm comfortable posting a bid/ask spread that is only 40 mils, I'd be willing to post on the inverted exchange. If I need a bid/ask spread that is larger than 40 mils, I won't post on that inverted exchange.
    If we moved to a system that removed all make rebates, then spreads would simply widen for certain names.