Subsidizing Liquidity: The Impact of Make/Take Fees on Market Quality

• Author: ANDREAS PARK,KATYA MALINOVA
• Date: 01 April 2015
• Published date: 01 April 2015
• DOI: http://doi.org/10.1111/jofi.12230

THE JOURNAL OF FINANCE •VOL. LXX, NO. 2 •APRIL 2015

Subsidizing Liquidity: The Impact of Make/Take

Fees on Market Quality

KATYA MALINOVA and ANDREAS PARK∗

ABSTRACT

Facing increased competition over the last decade, many stock exchanges changed

their trading fees to maker-taker pricing, an incentive scheme that rewards liquidity

suppliers and charges liquidity demanders. Using a change in trading fees on the

Toronto Stock Exchange, we study whether and why the breakdown of trading fees

between liquidity demanders and suppliers matters. Posted quotes adjust after the

change in fee composition, but the transaction costs for liquidity demanders remain

unaffected once fees are taken into account. However, as posted bid-ask spreads de-

cline, traders (particularly retail) use aggressive orders more frequently,and adverse

selection costs decrease.

THE EQUITY TRADING LANDSCAPE has changed dramatically over the past two

decades, bringing with it a host of new policy concerns. Technologicalinnovation

in the 1990s allowed the entry of fully electronic trading platforms, known in

the United States as electronic communication networks (ECNs). Subsequent

regulatory reforms facilitated competition among trading platforms, eliminated

∗Katya Malinova and Andreas Park are with the University of Toronto and Copenhagen

Business School. Financial support from the SSHRC (grant number 410101750) is gratefully

acknowledged. We thank Cam Harvey (the Editor) and an anonymous referee, as well as

Robert Battalio, Gustavo Bobonis, Jean-Edouard Colliard, Hans Degryse, Thierry Foucault, Joel

Hasbrouck, Ohad Kadan, Ingrid Lo, Albert Menkveld, Roberto Pascual, Ioanid Rosu, Roger Sil-

vers, Elvira Sojli, Mark van Achter, Jo van Biesebroeck, Martin Wagener, and Gunther Wuyts for

insightful discussions and Tayo Akinbiyi, Andrew Bolyaschevets, Michael Brolley, James Cheung,

Zuhaib Chungtai, Steve El-Hage, and Nathan Halmrast for research assistance. We gratefully

acknowledge many insightful comments from seminar participants at the 2012 AFA, the 2011

NYU Stern Microstructure Meeting, the 7th Central Bank Workshop on Market Microstructure,

the 2011 CNMV Conference on Securities Markets, the 9th International Paris Finance Meeting,

the Edwards Symposium, the 2011 CEA, and KU Leuven, Erasmus University Rotterdam, VU

Amsterdam, HEC Paris, WLU, KIT, and University of St. Gallen. We also thank attendees of

the 2011 TSX Trading Conference and attendees of staff presentations at CIBC, TD Securities,

RBC Capital Markets, ScotiaCapital, the Ontario Securities Commission, and Alpha Trading for

valuable comments. The Toronto Stock Exchange (TSX) kindly provided us with a database, and

we thank Alex Taylor for insights into the data. TSX Inc. holds copyright to the data, all rights

reserved. It is not to be reproduced or redistributed. TSX Inc. disclaims all representations and

warranties with respect to this information, and shall not be liable to any person for any use of

this information.

DOI: 10.1111/jofi.12230

509

510 The Journal of Finance R

the privileges of incumbent exchanges, and ultimately forced incumbents to

abandon physical trading floors and become electronic limit order markets.1

In a limit order market, a trader can either specify the desired price and quan-

tity by posting a limit order or accept the terms of a previously posted limit order

by submitting a market order. To compete for trading volume, during the last

decade most equity trading platforms in North America have introduced cash

incentives for posting attractively priced limit orders. These cash payments

are part of an incentive scheme known as maker-taker pricing. Understand-

ing the impact of trading platforms’ innovative offerings, such as maker-taker

pricing, has become increasingly important in the new competitive environ-

ment. In the past, exchanges in North America were nonprofit entities with a

mandate to serve their members. Facing stiff competition, they converted to

shareholder-owned corporations, raising concerns that their profit-motivated

“incentive schemes may run counter to the integrity of pricing and investor pro-

tection.”2

In this paper, we empirically analyze the impact of the maker-taker pricing

model on market liquidity, trader behavior, and trading volume. The Interna-

tional Organization of Securities Commissions (IOSCO) defines maker-taker

fees as “a pricing model whereby the maker of liquidity, or passive [limit] or-

der, is paid a rebate and the taker of liquidity, or aggressive [market] order, is

charged a fee.”3Maker rebates aim to both improve liquidity, by rewarding its

provision, and increase trading volume, yet theoretical studies show that such

rebates need not affect liquidity and that trading volume may, in fact, decline.

Angel, Harris, and Spatt (2011) argue that introducing a maker rebate that

is financed by a taker fee should have no effect, because in competitive markets

prices would adjust by the amount of the rebate. Colliard and Foucault (2012)

formalize Angel, Harris, and Spatt’s intuition and prove, without relying on

perfect competition, that, in the absence of frictions, only changes in the total fee

retained by the exchange affect liquidity and trading volume. Foucault, Kadan,

and Kandel (2013), in contrast, show that trading volume may increase or

decrease (depending on the model parameters), even in the absence of a change

in the total fee, because a fixed tick size prevents prices from neutralizing the

effect of the maker rebate.

In this paper, we use the introduction of a maker rebate on the Toronto

Stock Exchange (TSX) to identify the extent to which the breakdown of the

total exchange fee into the maker rebate and the taker fee affects market

liquidity and trading volume. Prior to October 1, 2005, liquidity takers paid

two basis points of the dollar value of their marketable orders, and liquidity

1Examples are: for the United States, Reg. ATS in 1999 and Reg. NMS in 2007; for Canada, the

ATS Rules (NI 21-101, NI 23-101, and OSC Rule 23-501) in 2001; and for Europe, MiFID in 2004.

2See Campos, Roel C., March 10, 2006, “Regulatory role of exchanges and interna-

tional implications of demutualization,” Securities and Exchange Commission, available at

http://www.sec.gov/news/speech/spch031006rcc.htm.

3See IOSCO Consultation Report, July 2011, “Regulatory issues raised by the impact

of technological changes on market integrity and efficiency,” available at http://www.iosco.

org/library/pubdocs/pdf/IOSCOPD407.pdf. The SEC (2010) offers a similar definition.