High frequency trading and rebates

High frequency trading is very much in the news these days with controversies about flash trades, rebates and so on. In this context, this paper by Foucault, Kadan, and Kandel is very interesting (hat tip Aleablog). It develops a model which explains why it may be optimal for exchanges to pay market makers for trading (in the form of rebates) while charging market takers for trading.

The paper discusses the determinants of what they call the make-take spread – the difference between the (possibly negative) fees charged to market makers and the (positive) fees charged to other traders. I found it more convenient to think in terms of the take-make spread (or the negative of the make-take spread) which can be interpreted as the subsidy to market makers.

The paper shows that a reduction in the tick size increases the optimal subsidy to market makers. They argue therefore that decimalization might have been an important factor in the emergence of rebates to market makers.

The subsidy for market makers is greater when there is a small number of market-makers relative to the number of market-takers. Quote driven markets tend to be dominated by a small number of market-makers and the rebates offered by these exchanges is in line with the predictions of the paper. The fact that order driven markets do not subsidize limit orders relative to market orders is also consistent with their model because these markets are characterized by large number of participants using limit orders.

While these are useful contribution, the paper still left me uneasy at the end. Why are quote driven markets unable to attract a large number of market makers when order driven markets have no difficulty attracting millions of limit order users? Is there something fundamentally wrong with quote driven markets that make them inherently anti-competitive leading to a cosy oligopoly of market makers?

Posted at 7:09 pm IST on Sun, 9 Aug 2009         permanent link

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