Paying Market Makers

Exchanges suggest payments could boost trading in stock of smaller companies.

Regulators should consider allowing smaller companies to pay broker-dealers to make markets in their shares as a way to spur trading and encourage initial offerings, NYSE Euronext and Nasdaq OMX Group Inc. executives said Tuesday.

Such a change in regulations would increase the ability of investors to buy and sell stock by boosting market makers’ economic incentives, Joseph Mecane, co-head of U.S. listings and cash execution at NYSE Euronext, said at a subcommittee meeting of the House Committee on Oversight and Government Reform. The Financial Industry Regulatory Authority, which oversees almost 4,500 brokers, banned the practice in 1997, he said.

U.S. policy makers, regulators and exchanges are seeking ways to improve trading in smaller companies in order to encourage more of them to go public. Rules adopted in the last decade have driven up costs for companies that want to sell shares and shifted trading incentives toward higher capitalization stocks, according to a report last month by the IPO Task Force, a group of private securities professionals.

“Allowing issuers to compensate market makers could help,” Mecane said. NYSE Arca, a venue run by NYSE Euronext, will propose rules to the Securities and Exchange Commission for a pilot program in which issuers pay market makers to supply liquidity in exchange-traded funds, he said.

If the results benefit investors by increasing volume, regulators should “try a second experiment with some stocks and see if it has the same effect,” Mecane said.

“There is a conflict inherent in a situation where a company itself is paying a liquidity provider to make a market in a stock,” Mecane said. Since the prices of ETFs “are generally linked back to the underlying securities, there’s less opportunity for manipulation,” he said.

Nasdaq OMX also plans to propose liquidity payment programs by issuers in its new BX Venture Market, which caters to smaller companies, and for “less-followed ETFs,” Eric Noll, executive vice president for transaction services, said today. The exchange company would collect payments from the issuers and distribute them to market makers, he said.

The ETF proposal will be sent to the SEC this week and the BX Venture proposal by the end of the year, Noll said in a phone interview. Nasdaq OMX has had “great success” in increasing liquidity in stocks on its First North market, a European venue for smaller companies that has a program enabling issuers to compensate market makers, he said today.

‘Positive Influence’

“Such agreements would allow small companies to produce an orderly, liquid market for their stocks,” Congressman Patrick McHenry, a Republican from North Carolina, said at the hearing. “Research has shown that these agreements, already permitted overseas, have led to a positive influence on liquidity for small public companies.”

The exchange executives said the programs would require disclosure to investors about how the payments work. European stocks listed on Euronext and other markets have employed similar programs to generate liquidity in their shares. One difference is that many of these arrangements are in countries with “more monopolistic environments” where trading is concentrated in the main exchange, Mecane said.

Trading in the U.S. is spread over 13 exchanges, several additional stock markets and more than 40 dark pools or private venues that don’t display bids and offers. Broker-dealers can also internalize orders from retail securities firms by trading against them within their walls and can find counterparties for institutional customers to trade with away from exchanges.

Market makers operating on most U.S. exchanges generate revenue from the spread between the bid and offer prices as they buy and sell shares, and by incentives exchanges pay to spur liquidity. Mecane said NYSE Euronext’s liquidity payments often aren’t enough to compel market makers to trade more shares of smaller stocks at higher bids and lower offers.

“The unintended consequences of the market fragmentation has been a lack of liquidity and price discovery in listed securities outside of the top 100 traded names and a disturbing absence of market attention paid to small growth companies by all market participants including exchanges,” Noll said in written testimony. He added that competition among venues has also reduced costs for investors and “improved execution quality in already listed securities.”

IPOs Since 1991

An annual average of 547 companies went public from 1991 through 1999, and 192 since then, according to data from the IPO Task Force. The share of IPOs that raised less than $50 million has also shrunk in the post-1999 period, compared with the earlier period in the 1990s, the data showed. Additional U.S. jobs will be created if more companies hold IPOs to expand their businesses, the group said.

Tim Quast, founder of ModernNetworks IR LLC, a Denver-based consulting firm that advises Cisco Systems Inc., Accenture Plc and other companies about market structure and trading, said in a phone interview that the exchanges’ plans “smack of a self- serving objective.”

“Shifting the cost of making markets to companies is not the solution to a capital formation problem,” Quast said. “Incentives are not a proper way to create healthy markets. It’s not a reflection of real buy and sell demand.”

NYSE Euronext also supports price increments of more than 1 cent for some stocks to increase investors’ ability to buy and sell. Smaller stocks may warrant increments of 5 cents or 10 cents to allow orders to pool at a smaller number of price levels instead of 1-cent ticks, Mecane said.

 “We think it could actually improve liquidity,” he said. Such a program “would need to be an industry-wide solution” that applies across all exchanges, Mecane said.

As part of the effort to encourage smaller companies to go public, U.S. policy makers and regulators should review the compliance requirements of the Sarbanes-Oxley Act of 2002 that raised legal and auditing fees for firms, Noll said in his testimony. New public companies could be “temporarily exempted” from Sarbanes-Oxley requirements for a set number of years or until their company reaches a specified value, he said. Audits could be done twice a year instead of quarterly, he said.

Rule changes that would lower costs for companies considering IPOs and experiments with regulations that determine how stocks trade should go hand in hand, Noll said.

“Small companies do not trade like Microsoft, Intel, Apple or Oracle,” Noll said. “Building and maintaining liquidity is a constant challenge.”

Bloomberg News


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