The Effect of Maker-Taker Fees on Investor Order Choice and Execution Quality in U.S. Stock Markets

Abstract

Equity exchanges competing for orders are using new pricing strategies. Typically, liquidity suppliers are compensated and liquidity demanders are charged. This pricing structure is controversial because of its potential effects on investor order choice, market quality, trader welfare, and economic efficiency. I develop a theoretical model of maker-taker fees in the presence of a broker and equity exchanges and test the model empirically using order level data from SEC Rule 605. The broker charges investors a commission and endogenously chooses to route orders to a dealer or equity exchange. The exchanges keep a portion of the taker fee as profit and pass the remaining amount to the broker as a maker rebate when its order providing liquidity executes. The theoretical model predicts that as the taker fee and maker rebate increase, holding constant the amount kept as profit by the exchange: (1) the bid-ask spread declines, (2) the total trading cost increases, (3) the trader participation falls, (4) the proportion of marketable order shares rises, and (5) the non-marketable limit order fill rate increases. These implications are different from those of the model by Colliard and Foucault (2012), because my model implies that changes in the split of trading fees between liquidity suppliers and demanders affect order choice and thereby execution quality. I find empirical evidence consistent with my model’s predictions. In particular, as the taker fee and maker rebate increase, holding constant the amount kept as profit by the exchange: (1) the bid-ask spread declines, (2) the trader participation falls, (3) the proportion of marketable order shares rises, and (4) the non-marketable limit order fill rate increases.