As soon as Michael Lewis’s new book Flash Boys hit the Kindles, the debate over high-frequency trading (HFT) – and especially the “maker-taker” pricing prevalent for some time in the high-frequency trading world – hit a new high. So what are they all talking about? Those of you who have attended one of GFMI’s Introduction to Electronic Trading programs will already have a handle on the key issues; for everyone else, here is a brief explanation.

High-Frequency Trading and the Stock Exchanges

Stock exchanges are venues where market participants, from the smallest individual investors to the largest hedge funds and institutional investors, buy and sell securities. Think of them as the modern day Buttonwood Tree, the place where centuries ago people gathered to buy and sell shares to each other, and which was the birthplace of the New York Stock Exchange (recently acquired by the electronic trading firm ICE, the Intercontinental Exchange). Trading on today’s exchanges is conducted electronically, and speed of execution on the major exchanges has risen dramatically over the past years to ultra-low latency levels. (Latency refers to the time for a trade to be executed; ultra-low latency meaning ultra-high speed.) This is high-frequency trading.

Maker-Taker Debate within High-Frequency Trading

The whole maker-taker debate emanates from the exchange fee schedules, order types, and order routings that govern trading. The term “maker-taker” comes from the fee schedule of exchanges that charge a participant money for removing or “taking” liquidity from the exchange, but pay a participant money (a “rebate”) for adding or “making” liquidity for the exchange. Generally speaking, if a participant makes more liquidity than they take, that participant earns money from the exchange at the expense of other participants who take more than they make.

Exchanges define orders that make or take liquidity, the simplest examples being a “market” order that is executed at the best available price, and a “limit” order that is left on the book of the exchange at a specified price (or “limit”). Orders left with the exchange provide liquidity to the exchange, and therefore receive rebates when executed, whereas market orders hitting those limit orders take liquidity from the exchange and are charged fees.

Tipping the Scales in High-Frequency Trading

High frequency traders employ a variety of algorithms executed at ultra-high speeds to discern market patterns and order flow, thereby enabling them to place or retract limit or other liquidity providing orders in a way that provides them with a preponderance of rebates vs. payments. For instance, a hedge fund implementing a quantitative algorithmic trading model that identifies a stock trading on a rising price oscillation, could place limit sell orders in front of the rising market price to collect a series of rebates as those limit orders are executed, and thereby benefit from the maker-taker pricing model.

I have spoken to investment managers who claim that prior to high-frequency trading, their fees and rebates would basically break even, but after the start of high frequency trading they would pay fees 80% of the time vs. receiving rebates 20% of the time. With that kind of experience, the maker-taker pricing model will certainly receive more and more scrutiny.

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