Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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,
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


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