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Designing a Market Making Program for IEX

Traders Magazine Online News, January 29, 2018

Eric Stockland

One of the advantages of building a brand-new listings exchange is the opportunity to design our offering to solve market problems in a way that aligns with our principles.

Part of our role as a listings exchange will be to support price discovery for IEX-listed stocks. As Iíve written†before, the price of†actual, completed trades - especially large trades at the midpoint† - are the most valuable indications of the fair value of a stock because they show where real investors are willing to transact.

Another form of price discovery is displayed quotes, which provide an indication of†potential†trading interest. But supplying those displayed quotes - market making - is a low-margin business. In fact, based on my experience as a former market maker, most firms earn, on average, less than a few hundred dollars of profit per day in each of the top ~500 stocks.[1]

Given these dynamics, IEX sought to create a differentiated incentive program that would attract a diverse set of firms to invest in the upfront costs to quote in all IEX-listed stocks from the first day the first public company lists on IEX - and do so in a way that fits our overall philosophy.

The Problem with Rebates & a Speed-Driven Marketplace

The way displayed quotes are currently incentivized in the market - rebates - has serious problems. Most obviously, they can create a conflict around client order routing if brokers prioritize rebates over best execution.

But rebates also fall short in a number of other ways when it comes to building a diverse, healthy marketplace. Rebates alone havenít been enough to prevent large brokers from leaving the exchange market making business - they donít make up for the fact that (given their responsibilities to customers) those brokers canít compete with the fastest traders when getting into and out of the market. They also fuel disproportionate quoting in large-cap, high-volume stocks, and despite rhetoric to the contrary,†the evidence shows†that they do not meaningfully narrow spreads in illiquid stocks. Or said a different way: rebates incentivize quoting the most where it is needed the least, and least where it is needed the most.

Therefore, we set out to design a smart incentive program that attracts a diverse set of firms to quote meaningfully in all IEX-listed stocks, not just the most liquid names, while avoiding the problems created by rebates. We also sought to align the incentives of our key stakeholders?ó?investors, companies, brokers, and market makers - and we believe that our market making program does just that.

The IEX Enhanced Market Maker†Program

The IEX Enhanced Market Maker (IEMM) Program offers a discount on trading fees to market makers when they meet stringent market making requirements in IEX-listed stocks with only their†principal order flow†(not that of their clients).[2]

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