BATS Drafts Market Maker Loyalty Plan

December 21, 2011

BATS has a plan to reward market makers for staying in the game.

BATS Global Markets, the third-largest U.S. stock exchange, filed a proposal with the Securities and Exchange Commission to establish a program designed to reward market makers with financial incentives for maintaining order flow in stocks and ETFs. It didn’t specify dollar amounts.

In an immediate sense, the so-called Competitive Liquidity Provider Program is designed with BATS' new U.S.-listings business in mind. BATS launched the primary listing unit, which puts it on par with the New York Stock Exchange and the Nasdaq, earlier this month. It hopes the program will attract fund companies to its venue because the program encourages active market making in securities listed on BATS. It doesn't yet have any primary listings, but aims to grow the business over time.

But more broadly, what BATS is proposing appears to be designed to keep market makers in the center of trading traffic, even when markets turn volatile. The “Flash Crash” of May 6, 2010 continues to be the ultimate example of how quickly modern electronic markets can unravel when spooked market makers withdraw from the market completely.

Regulators at the SEC have been hard at work grappling with questions about market structure for more than a year, particularly in the aftermath of the Flash Crash. On that day, the Dow Jones industrial average fell 10 percent in the space of minutes, only to rebound as quickly and close about 4 percent lower. The entire episode began around 2:30 p.m. Eastern time and was over in less than 30 minutes.

Market makers continue to defend their actions during the Flash Crash. They say that they no longer have any incentive to provide and preserve liquidity the way they did when they controlled order flow of specific securities in the old days. For investors, the price to pay for relatively stable liquidity was in wide  bid-ask spreads that market makers established, and that now look exceedingly wide by modern standards.

Indeed, one clear advantage of the “high-frequency” electronic trading that characterizes modern financial markets is that investors are no longer nickel-and-dimed by wide bid-ask spreads. But  in exchange for more efficient markets investors must now buy stocks and ETFs on a plethora of increasingly electronic exchanges where market makers have no incentive to support order flow. Human market makers devoted to match buyers and sellers, even in stormy markets, are now mostly gone.

That means liquidity can dry up in a heartbeat and, more to the point, some stocks and ETFs don’t get the support they need from market makers, particularly in the early days after their launches.

“One of the many challenges for today’s issuers is attracting liquidity to their stock, and we believe we’ve developed a unique program that addresses this very issue,” Joe Ratterman, chairman and chief executive of BATS Global Markets, said in a press release.

BATS submitted the paperwork to the SEC on Dec. 16, and it's not clear how long the SEC will take before it responds to BATS.

Nuts And Bolts Of The Program

Through the BATS program, liquidity providers would compete for a daily reward by posting competitive quotes in a stock or exchange-traded product (ETP). They would be rewarded based on their continuous daily quoted size at the National Best Bid/Offer (NBBO) in the securities for which they are registered CLPs, the filing said.

The proposal by BATs has special implications for newly listed exchange trade products that aren’t trading very heavily and also for securities that are the focus of speculative trading.

To avoid ETP sponsors from being dissuaded from initially listing their products on the BATS Exchange, BATS proposes to permit ETPs that are initially listed on the BATS exchange to remain in the program regardless of the ETP’s consolidated average volume (CADV).

ETPs with a CADV equal or greater than 2 million shares for two consecutive months, or those that have been subject to the program for two years wouldn’t be eligible.

The filing said that CLPs will be subject to both a daily quoting requirement in order to be eligible to receive the financial incentive and a monthly quoting requirement in order to remain qualified as a CLP.

To qualify as a CLP market maker, BATS members require a number of qualifications including adequate technology to support the Exchange’s systems, a significant quoting and volume performance, and adequate barriers in place between CLP units and research and investment divisions.



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