NASDAQ New Rule: ETF Issuers Can Pay Market-Makers Quoting “Thinly-Traded” products


As duly noted by industry expert TABB Forum, ETFs with little-known or illiquid underlying securities are a hard sell without liquidity.  “Whether you loved or hated them, major exchange specialists (including this blogger) played a vital role to help nurture small listings, and the problem of how to incent liquidity provision is an ongoing industry debate. Without an extra incentive, market makers don’t consider it worth the risk..”

NASDAQ apparently understands this challenge. As reported by TABB, and in a rule filing submitted to the SEC, the exchange that will soon be home to Facebook proposes to put ETF issuers in the driver’s seat by facilitating issuer payments to market-makers in consideration for those traders quoting and trading those pesky, “hard-to-trade” aka “illiquid” ETF products that seem to trade by appointment only.

According to the TABB piece, “..The rule filing is waiting to be ‘noticed’ by the SEC, which will start turning the wheels of the rule filing and formal commentary process. If ultimately approved, the writing is on the wall for equities.There is little on the regulatory table at the moment to improve market quality, but prior success of a similar program abroad and political concern over how to improve the lot of smaller securities at least gives this proposal a decent chance of making it to the pilot…”

Not everyone fully agrees. At least one former ETF market-maker who was invited by NASDAQ to help formulate their new proposal believes it could open Pandora’s box (even if some think the Genie is already out of the bottle..)According to the former principal trader, who is now a self-described ‘best execution concierge’ within the ETF space,
“Unless regulators are convinced otherwise and the rules of engagement change, many will argue the genie is already out of the bottle with respect to payment for order flow, and payment for improved liquidity is simply a subset of this approach.  But, when reviewing the current iteration of this particular proposal, it would seem to add a whole new dimension with respect to complexity, if not potential for conflict.”

“The notion that a particular ETF is ‘illiquid’ is often premised on two, often misleading assumptions: (i) the screen market displays the actual interest in the name, and (ii) the ‘broker’ being used to execute the order in a seemingly illiquid name has the wherewithal to properly source liquidity for that particular product.

It remains to be seen whether offering a ‘bounty’ with a complex set of rules and conditions as a means to incentive principal traders to [substantially] improve actionable liquidity in the ETF cash product will actually work.  Liquidity providers bid or offer because there’s an arbitrage opportunity between the cash ETF and the underlying components; offering a bonus, on top of the potential for the arbitrage profit might be intriguing, but it could also result in unexpected consequences.”

Many thanks to TABB for taking a lead in this evolving story!