We in equity markets sometimes take for granted the level of transparency and the quality of information available. We forget how that creates a competitive market for bids and offers that benefits all investors.
What a National Bid and Best Offer (NBBO)? Learn more here.
Not all markets have bids and offers that are publicly available. Some don’t even disclose last trade. That makes it hard to value your portfolio or decide when it’s efficient to reallocate assets. In fact, studies have shown that the lack of a protected bid and offer cost investors well over a billion dollars a year – in markets that trade a lot less than the $70tr US stock market.
Market Quality is Important to All Investors
The public (“lit”) prices found on US equity exchanges are important for all investors, as they represent volume and prices which can be traded by investors as well as arbitrageurs.
But perhaps more importantly, lit prices set the bounds for off-exchange trades too.
This means a more competitive exchange quote should also reduce costs for retail and dark pool investors, even though their trades usually happen off-exchange.
So how do we incent more competitive spreads in US markets?
Tighter Spreads Reduce Costs
One thing we learned from the tick pilot is that wider spreads increase costs for investors. So the tighter we can make spreads, the lower transaction costs should go.
Data shows that not all exchanges are good at providing consistently tight spreads. Given the current debate around access fees, it’s important to note that the best spreads are found most often on markets that reward liquidity providers. Not surprisingly, these markets also typically have the best liquidity too.
Competition for the Quote Tightens Spreads
We think the best way to tighten spreads is to encourage competition for the NBBO.
We’re not alone – when the SEC invented the SIP revenue allocation formula they clearly agreed – as they decided 50% of the SIP revenue should reward those who post lit liquidity at the best bid and offer.
In Europe corporates can pay for market makers. However in the US that’s not allowed, so it’s only exchanges, and only via liquidity rebates, who can incentivize liquidity provision and better market quality.
Data in the chart below again shows that markets with incentive programs are far more likely to be contributing to competition for the NBBO.
However, because US ticks are mostly very small and less than a few basis points, there are few exchanges with quotes at the NBBO most of the time – even in S&P500 stocks.
By rewarding liquidity providers, rebates encourage tighter spreads and deeper markets.
But liquidity incentives not “free money” for providers. That’s because not every fill on the “near touch” (bid for a buyer, offer for a seller) represents spread capture. For many stocks, a fill can represent adverse selection – often caused by larger or “more informed” traders.
Competitive market forces then optimize the economics of spread compression by weighing the value of the adverse selection against the liquidity provider rebates earned. Somewhat ironically, rebates paid to liquidity providers even benefit liquidity takers, who despite paying the take fees, benefit from tighter spreads and increased depth on their spread crossing trades.
What Might a World Without Incentives Look Like?
Note that despite the wide spreads in some venues, the charts above only show data for S&P500 stocks, and only calculate spread when a 2-sided market actually exists.
What is perhaps the most surprising result of this study is how uncommon two-sided markets actually are – especially for thinly traded stocks.
The data below shows the percentage of all stocks with a 2-sided market at least half of the time, by venue. Note that this chart isn’t looking for “competitive” 2-sided markets. It’s looking for ANY bid and offer on a ticker.
Amazingly, markets with high latency are one-sided (or worse) most of the day across more than 6,000 stocks. That likely highlights the additional costs delays create, which act as a disincentive for market makers.
It’s less surprising that inverted markets are more likely to be one-sided – as they’re most valuable to those who want queue priority on the “cheap” side of the spread.
Importantly, these three charts show maker-taker markets, with incentives for liquidity providers, are the only markets with a competitive quote, tight spreads, and a two sided market for almost all stocks. That, and an efficient close, are two critical metrics for issuers.
It’s important to connect all this data to a number of the debates occurring right now. The Access Fee Pilot proposal will significantly affect how rebates can be used to incent two-sided liquidity and maintain market quality. As the data in these three charts show, that’s also especially important to thinly traded stocks – the same stocks that the SEC’s Tick Pilot was trying to help.
Attracting more IPO’s to the US market is good for everyone. It’s especially important that we don’t harm thinly traded market quality.
More from Economic Research
Three Charts that dispel the Price Improvement Myth