April 12 (Bloomberg) -- Nasdaq Stock Market asked the U.S. Securities and Exchange Commission to allow companies sponsoring exchange-traded funds to pay market makers about $200 per day to quote their shares more aggressively.
The practice, currently illegal in the U.S., would spur quoting and transactions in ETFs that trade less than 2 million shares daily, benefiting investors by making more volume available to buy or sell at better prices, Nasdaq told the SEC in a filing published on April 6. The exchange said it would begin the program, which regulators must approve before it can be implemented, as a one-year study. The SEC rejected two earlier requests before they reached the public comment stage.
U.S. exchanges are seeking ways to boost the number of shares that can be bought or sold at or near the best prices in less-active securities. Executives from Nasdaq OMX Group Inc. and NYSE Euronext in New York told members of Congress in hearings in November that they intended to propose pilots enabling issuers to pay market makers for their services, mimicking efforts employed in Europe for smaller corporations.
“If ETF issuers want to incentivize market makers for services they provide, there should be mechanisms in place for that,” Reginald Browne, co-head of the ETF group at Knight Capital Group Inc. in Jersey City, New Jersey, said in a phone interview. “With more than 50 markets in the U.S., there’s just not enough incentive for market makers to bear the risk.”
Knight makes markets in more than 625 ETFs on Nasdaq, NYSE Arca and BZX Exchange. The company is also one of the main market makers for companies on NYSE and owns almost 20 percent of Direct Edge Holdings LLC, an exchange operator in Jersey City, New Jersey. Browne said the fees issuers pay should be negotiated instead of standardized, as Nasdaq is proposing.
There were more than 4,200 exchange-traded products globally with $1.52 trillion in assets at the end of 2011, compared with 106 with $79 billion in 2000, according to data compiled by BlackRock Inc. Of the 1,098 U.S. ETFs, fewer than 10 percent traded more than $40 million a day, the data showed.
“It’s a tough problem they’re trying to solve,” Michael Bleich, chief executive officer of Scout Trading LLC, a market- making firm in New York, said in a phone interview. About 70 percent of Scout’s volume is in ETFs. “Investors looking at a new product may want to invest but someone must provide a liquid market,” he said. “In the ecosystem of trading activity, it may not be profitable for market makers, including ourselves.”
Nasdaq’s program would give ETFs that might otherwise languish a chance to build volume and attract buyers by providing better prices, Browne said. While products that later fail to draw assets may not have appealed enough to investors, they at least would have had a chance, he said.
The Financial Industry Regulatory Authority, which oversees more than 4,400 U.S. brokers, banned payments to market makers in 1997 to improve investor confidence. Finra said at the time that the decision to make a market in a security should be based on supply and demand, the firm’s expectations about trading, its inventory of shares, and competition. It shouldn’t be influenced by payments from issuers, the regulator said.
Finra plans to exempt market makers in exchange programs approved by the commission from the prohibition on taking payments, Nasdaq told the SEC.
Tim Quast, founder of ModernNetworks IR LLC, a Denver-based consulting firm that advises EMC Corp. and other companies about market structure and equities trading matters, said in a phone interview that exchanges shouldn’t be allowed to treat issuers differently and that payments to market makers shouldn’t be used to stimulate liquidity.
Next page: Incentivized trading