Recently, FINRA put out a request for the ETF industry to comment on lifting Rule 5250 — a rule put in place long before ETFs were recognized as the vehicle of choice for the modern investor, a rule that prevents ETF issuers from properly incentivizing market makers.
As it stands today, ETF market makers are compensated through a "maker-taker" model, paid for providing liquidity and paying in for taking away liquidity. Those rebates are enhanced when taking on market maker obligations, which include continuous quoting of a two-sided market within a predefined spread range and a minimum acceptable amount of depth on the bid and ask.
While any market maker can trade ETFs opportunistically, only the lead market maker enjoys the enhanced rebates that the "LMM" programs offer. However, as market fragmentation continues, the primary listing venues where trading is eligible for the enhanced rebates only see fractional volumes.
Further, as ETFs evolve from trading instruments to buy-and-hold strategies, incentivizing by trading volume doesn't amount to much. In fact, we ran the numbers and found the incremental rebate difference between being a lead market maker and any other market maker in a median volume ETF comes out to precisely $4.75 per day.
Compounding the problem of low incentives is the issue of market maker concentration. Eighty-seven percent of all allocated ETFs on the New York Stock Exchange are spread out among only five different market making firms.
In other words, if one of those five firms suffered, a rogue trader, a fat-finger mishap or even a strategic decision to exit the market making business, the ETF industry could see hundreds of funds without a lead market maker and without the proper incentives to entice another to step up in their place.
