An interview with David Harris, CEO of CBOE Stock Exchange (CBSX)

David Harris is the president and CEO of CBOE Stock Exchange, which was created by the Chicago Board Options Exchange and four market-maker partners in 2007. In October 2010 CBSX inverted its maker-taker pricing and now gives rebates to liquidity takers. He spoke with Sarah Rudolph about the exchange’s new pricing model and how it fits in with trends in the equities industry.

Q: There has been a trend in recent years for exchanges to adopt a maker-taker pricing model, but now a few stock exchanges, such as CBSX, are harkening back to an older model that rewards liquidity takers. Can you talk a little bit about that decision, and what types of market participants were you looking to appeal to?

A: At CBSX, liquidity takers receive a very high rebate of 14 cents per 100 shares, and we charge liquidity providers 18 cents per 100 shares. This pricing model incentivizes liquidity takers to come to exchange markets first.

For most execution venues, when high rebates are used to attract liquidity providers, liquidity takers pay a correspondingly high amount to remove liquidity. For many market participants, markets that charge a lot to remove liquidity are usually further down the order routing table when it comes to routing priority. By rebating the liquidity taker with the very high rebate of $0.0014 per share , we are incentivizing liquidity takers to make CBSX first on their routing table.

In the equity world, exchanges, in many cases, execute ‘exhaust’ order flow from broker dealers and dark pools. This is usually not very good order flow to provide liquidity to. We are trying to change that with this pricing. The resulting order flow should be higher quality and more profitable to provide liquidity to. So liquidity providers are willing to pay to interact with it.

There is not a particular participant that our pricing model is geared towards. It’s a broad-based offering that should appeal to any liquidity taker, although market participants who have been most aggressive in taking advantage of the pricing are algorithmic and proprietary traders who care very much about execution costs.

Q: What do you mean by higher quality order flow?

A: If a broker-dealer can internalize a marketable order profitably, they’ll do so. So a lot of order flow, especially retail and algorithmic order flow, gets internalized. This order flow is generally considered, at least in the short term, as “uninformed” order flow. If an order is not profitable to trade against, the order gets routed to an exchange as a last resort. For liquidity providers on exchanges, as more market participants decide that they don’t want to trade against an order, it becomes less and less ”desirable” to trade against.

We are changing the equation for our liquidity providers by paying for marketable order flow. The result of CBSX’s pricing has been a tighter effective spread than other markets, both lit and dark. As CBSX offers more profitable trading opportunities, liquidity providers will be more willing to offer better markets. This is good for CBSX and good for the displayed markets as a whole.

Since we launched our new pricing structure, our theory is being borne out. Liquidity providers continue to provide meaningful liquidity even though they’re being charged.

What’s exciting for us as a market is that the number of market participants trading on our market has broadened dramatically. When we first launched, we were dependent on our four founding partners. Now, we have an ever-broadening base of customers.

Q: You mentioned in another recent interview that CBSX had originally thought about a “variable” maker-taker model but that “the world was not ready” for such a model. What is a variable maker-taker model, and why is the world not yet ready for it?

A: We think that there are probably too many market centers being offered solely for the purpose of introducing a price structure that is intended to appeal to a particular market segment. For example, almost all of the major markets are running at least two order books, one offering high rebates, the other low take rates. This adds to the complexity and cost of trading.

Variable maker-taker allows liquidity providers to identify the amount of compensation that they require to provide liquidity on a stock-by-stock basis. For example, Liquidity Provider A may want a $0.003 rebate for providing liquidity in stock ABC, whereas Liquidity Provider B may be willing to provide liquidity for free or, in fact, pay to interact with liquidity takers. The rebates (or lack thereof) would be reflected in the effective price of a stock, priority in the order book would be established based upon effective price, and liquidity takers would route orders based, in part, on an effective price of a security.

This pricing convention recognizes that the cost of providing and taking liquidity differs on a stock-by-stock basis, and probably differs on a venue-by-venue basis. It also recognizes that the cost of liquidity provision changes as market conditions change. In any event, a variable maker-taker pricing structure breaks lit markets from their current static pricing structures, aids in true price discovery — which I think is warped by static rebates — and permits investors to achieve better executions.

CBSX has always prided itself on being innovative. The price structure we launched with four years ago became the pricing structure all of the other market centers gravitated to. We were also the first to use flash trading on the equity side of business to remain competitive with internalizing broker-dealers, and many markets copied our innovation. Now we’re the first stock exchange to meaningfully rebate liquidity takers. And someone will probably imitate that. When that happens, we will just innovate further – and, who can tell, maybe the next innovation will be variable maker-taker.

Q: Could you say anything about what types of strategies retail traders use CBSX for, including strategies that combine options and equities?

A: I think that is the big contribution that CBSX makes to retail investors — that we have cross-product trading. If an investor wants to engage in a buy-write strategy, it’s very easy to do as a single transaction at a very low cost. If you want to purchase $100 shares of IBM, for example, and write a call against that, there is no legging risk. We’ve seen steady growth in that type of trading. It’s a pretty consistent product offering for us.

Q: Any other products you are working on that you can talk about?

A: We are working on some projects which are not ready for prime time yet. But they are exciting and potentially transformative.

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