Blood, sweat, and tiers: how the SEC’s exchange rebates proposal could reshape US equities markets

To the impartial observer, the US Securities and Exchange Commission’s proposed rule 6b-1 may seem like an innocuous technical market reform. But the proposal to change the way exchanges compete for order flow from brokers has proved controversial, unleashing a heated debate about equity market structure.

At the heart of the proposal lies the system of tiered transaction pricing, where an exchange pays brokers rebates in proportion to the volume of orders they route to the venue.

But how exactly the SEC might change this setup is still an open question. The Commission has suggested banning volume-based transaction prices for brokers executing trades on behalf of customers. Exchanges could continue offering tiered rebates to members executing their own orders, but they would have to file monthly submissions, available to the public via the SEC’s Edgar system, disclosing how many members fell under each tier.

Alongside this main proposal, the Commission has also provided some alternatives, including banning volume-based transaction prices for all orders (including principal-based volume), and allowing exchanges to continue offering tiered rebates but requiring them to disclose details of how many members qualified for each tier.

The SEC has asked for comments on the main proposal as well as the alternatives it listed, encouraging market participants to have their say on the costs, benefits, and ramifications of the various ideas.

One vocal proponent of rule 6b-1 is IEX, a stock exchange launched in 2016 with the aim of attracting investors through transparent pricing practices and a more level playing field. Last year, IEX introduced its first rebates—albeit not in a tiered system—at $0.0004 per share for displayed adding. John Ramsay, IEX’s chief market policy officer, says the idea was to drive up lit quotes.

“We think the better answer would have been if rebates were just prohibited, but that is not on the regulatory menu anywhere that we can see. You have to be able to compete in the world that you live in, not the world as you would like it to be,” Ramsay says.

One of the complaints against the tiered rebates system used by larger exchanges is that it creates a conflict of interest between agency brokers and their clients. The brokers have an obligation to find their clients the best prices for assets, but also an economic incentive to route orders to the venues offering the biggest rebates. Without information on the rebates that brokers are receiving, it can be harder for investors to work out whether routing choices are being made based on execution quality.

In 2018, research conducted by Royal Bank of Canada found that 3,762 different pricing variables were used across exchanges to calculate fees and rebates.

“Anybody who’s trading on the exchange is not just paying that price or selling for that price. It’s heavily impacted by questions like, ‘Are they getting a tier rebate benefit? Are they paying a take fee?’ So, it’s much harder to figure out what the economics are. And that only benefits firms that profit from less transparency because if you can pay to have systems that arbitrage those different kinds of markets, knowing that other people can’t, then you benefit from the complexity,” Ramsay says.

Healthy competition?

Three exchange groups—Nasdaq, New York Stock Exchange, and Bats-Cboe—command more than 95% of US equity market trading, and it is these exchange families that reap the biggest benefits from the system of rebates.

The SEC has noted that smaller exchanges—like IEX—would likely gain market share from an end to tiered rebates. In a scenario where the rule decreases agency order flow concentration by 20%, 11 of the 16 exchanges which currently account for just 20% of the exchange market would gain on average 0.5 percentage points of market share each, according to analysis by the SEC.

In the rule proposal, the Commission wrote that, under the current market system, “newer or smaller exchanges may find it difficult to attract order flow away from the larger legacy exchanges given that a sizable portion of order flow is provided by the high-volume exchange members which qualify for the top tiers, and similar terms would have to be offered to those members to pull them away.”

A similar competitive concern applies in the case of brokers, too. Exchange members controlling less order flow sometimes route their orders through higher-volume brokers—who they would normally compete with—to access bigger rebates. This risks creating a vicious circle, where order flow is concentrated more heavily with the biggest brokers, who then qualify for even bigger rebates.

According to a 2020 study cited by the SEC in its proposed rule, both Nasdaq and Bats-Cboe have suggested that they give their largest clients a net payment each month, even after fixed costs like connectivity and market data are factored in.

All three of the major exchange groups filed comment letters objecting to the SEC’s proposal. Nyse’s letter said “the proposal suffers from myriad shortcomings, all of which stem from the Commission’s incomplete understanding of the reasons that broker-dealers engage in agency order flow, its selective view of competition in the market, and its failure to actually identify a regulatory problem that needs to be solved.”

These arguments were echoed by Cboe and Nasdaq in their comment letters, which highlighted a lack of evidence from the SEC that changes to the tier rebates system were justified and rational. They also said that the proposed rule could harm competition between exchanges and other market centers which could continue using rebate tiers, pointing out that it could drive more trading to dark pools.

But market participants are divided on what exactly healthy competition looks like. Those in favor of the proposed rule argue the current system provides an unfair advantage to the bigger brokers and exchanges; its detractors warn that the SEC could end up giving certain players a boost by changing the established system.

A market structure policy expert at a US market-maker says the SEC has failed to demonstrate that the changes would have their intended effect, or even to identify a concrete problem in the way equity markets already function. “By all accounts, competition is alive and well in the US equities market. Seeking to dampen that, to arbitrarily select winners and losers, or to assert that there’s an issue just because some exchanges have more market share than others, is a pretty significant departure from what the SEC typically focuses on,” they say.

The analogy of bulk goods warehouses has been used by both sides of the debate. Commissioner Hester Peirce, who does not support the proposed rule, wrote in a statement published on the SEC website that “economies of scale trigger discounts in almost every industry. You buy in bulk, and you pay less. Why should similar discounts be unavailable in this industry?”

But supporters of the rule say the opacity of the system of exchange rebates and the agency model of some brokerages make equities markets uniquely vulnerable to perverse incentives in the application of volume-based pricing.

IEX’s Ramsay does not find the analogy apt. He points out that bulk goods outlets like Costco do not make their best pricing available only to a handful of their biggest customers. And anyway, he says, “Nasdaq is in the business of trying to help people buy and sell stocks, they are not selling roast chickens.”

Market structure

In more than 80 comment letters submitted to the SEC, interested parties attempted to work out the proposed rule’s implications for the way equities markets operate.

The market structure expert at a US market-maker says market participants are having a hard time assessing the potential ramifications due to the variety of different options put forward in the proposed rule.

But one thing they say is clear is that it would considerably alter commercial dynamics and profitability models. “There are so many reasons why someone may choose to access a market indirectly versus directly. And if that use case stays the same, but the only thing that changes is it becomes more expensive because you are no longer able to get the benefit of volume tiers that today are passed through in some way, it’s hard to see how that’s a net benefit for the smaller firm,” they say.

Some critics of the proposed rule also say that it will have unpredictable effects on liquidity, which would likely be more fragmented across venues.

In 2019, the SEC implemented a transaction fee pilot, designed to analyze the impacts of the exchange transaction fee and rebate system on execution quality and order-routing behavior, helping to gauge whether they represented a problem worthy of further regulation. Several large exchanges challenged the pilot in court, and the DC Circuit Court of Appeals ruled against the Commission, saying that the pilot amounted to an experiment.

In the text for the pilot, the SEC said that it was not certain of the impacts that a change to the system of transaction fees and rebates would have, recognizing that “if the reduction in rebates and linked pricing harms liquidity, or causes more informed order flow to be routed to off-exchange trading venues, then the pilot may temporarily impair price efficiency and the price discovery process.”

IEX’s Ramsay says the proposed rule would enhance spreads and other measures of market quality. “One effect would be to make pricing benefits more broadly available to a larger number of firms, which means that for some stocks, you could have more brokers that are competing to put quotes up,” he says.

But the US market-maker source believes exchanges could use other mechanisms to protect revenues, like changing their net capture rates, for example. “There are a number of different levers that an exchange could pull in order to compete for market share. I don’t think taking one very specific tool that you use for competition off the table changes the overall dynamic fundamentally,” they say.

Another unclear impact of a change to volume-based rebates is the way it would affect trading in low-priced ‘penny stocks’. In the last few years, there appears to have been a significant uptick in transactions in the cheapest listed stocks.

Between the first quarter of 2021 and the end of 2023, the proportion of transacted volume in sub-$5 securities that was made up of stocks with an average price of less than one dollar shot up from 20% to nearly 60%.

This may be to do with the way that exchange rebates work—exchanges tend to reward members for the volume of stocks that they transact, rather than the value of those stocks. That creates an incentive for members to buy and sell lower-priced stocks, particularly toward the end of each month, when rebate tiers are calculated, as they try to increase their traded volume and get into a higher tier.

“You certainly have a larger preponderance of sketchier names that tend to be very low priced. That’s another aspect of the tier system that has created strange incentives that do not align with the goals of fair and efficient markets,” IEX’s Ramsay says.

The exact impact cannot be predicted, but any modification to the system of tiered rebates could change the way firms allocate capital among stocks across the value spectrum. Depending who you ask, this could help make US equity markets more efficient, or it could risk destabilizing an otherwise solid market structure.

Tech effects

The proposed rule is being closely watched by exchange members. If the suggestion of prohibiting tiered rebates for some order flow is adopted, it will change the calculus for routing decisions.

Mehmet Yanilmaz is a consultant with experience advising algorithmic trading operations that also have associations with brokers. These systems are designed to “route orders across different venues, constantly splitting orders,” Yanilmaz explains. “Such routing algorithms have to take these volume discounts into account, and that’s all going to change.”

With tiered rebates no longer available for some orders, routing algorithms will have to be rewritten to prioritize other factors. This can be an expensive operation, but sources say it is more likely to put a greater onus on sophisticated technology rather than actively putting smaller players out of business.

“There will be a massive redesign. But nobody’s going to go belly up because they have to retrofit the algorithms,” Yanilmaz says.

Under the current market structure, some smaller players sign contracts with large brokers to use their routers, with a limited amount of the rebates accessed by the large brokers passed onto the smaller players.

Changes to that system might mean that smaller firms can go directly to the exchanges. But Tim Lang, CEO of electronic execution technology provider Global Liquidity Partners, says this is not as straightforward as it sounds. In most cases, it would mean small firms becoming a member on dozens of different exchanges and dark pools. And then they would have to build their own routing capabilities. “Routing is a very, very sophisticated chess game,” Lang says.

How orders are routed under a system of modified exchange rebates will depend on what exactly is included in the SEC’s rule. It is likely that the ease of getting orders filled will become a crucial factor informing the choice of venue.

For the most part, participants in US equity markets are used to price-and-time priorities in the filling of orders. But sources say this could conceivably shift to a system of size-price-time priority, so that brokers representing separate orders as one could gain priority on the order book. That would effectively reintroduce the need for smaller firms to group orders together.

Another factor that will play into routing decisions is maker-taker fees, which reward market-makers for providing resting liquidity on exchanges. If one exchange secured permission to raise these fees, this could become a new battleground, with firms scrambling to find the venue offering the best value for their liquidity.

For Global Liquidity Partners’ Lang, the uncertainty of how markets might react to the proposed rule serves to underscore the importance of sophisticated routing technology: “That bit of chaos is actually an opportunity for people like us to solve the problem. And those that can react quickly and adjust their routing systems effectively and quickly will have the advantage.”