Liquidity Fees and the Fiduciary Duty of Best Execution

Back in 2015, the U.S. Securities and Exchange Commission’s (SEC) Division of Trading and Markets sent an official memorandum to the SEC Market Structure Advisory Committee, urging more cross-department discussion of the topic of “maker-taker” fees within equity securities exchanges.

As the trading and markets staff laid out, since the late 1990s, to attract order flows while incentivizing market participants to provide liquidity at the most competitive prices, many equities exchanges have adopted a fee structure where they pay a per-share rebate (or commission) to their members to encourage them to place “resting liquidity-providing orders” on their trading systems. If an execution occurs, the liquidity-providing “maker” receives a rebate, and the “taker” that executes against that resting order pays a fee to the market.

According to the SEC staff memo, this “maker-taker” fee model had already in 2015 started to generate significant attention and debate among market participants, with a particular focus on the effects maker-taker fees may have on market structure, broker routing practices, and investor interests. Heading into 2018 the debate remains important, sources suggest, and retirement plan fiduciaries may just want to do a little reading on the subject. 

In some clear ways the debate for and against the “maker-taker” fee structure parallels the Department of Labor (DOL) fiduciary rule reform efforts under the Employee Retirement Income Security (ERISA). Both conversations involve new and pressing questions about well-established business practices and the transparency (or not) of fees assessed to investors in an ever-more-complex market environment. 

In the SEC memorandum, the staff points out that one frequently expressed critique of the maker-taker system is that it “may create a conflict of interest for brokers who have a legal duty to seek best execution of their customers’ orders.” Other commenters have highlighted market transparency concerns relating to the maker-taker pricing model, SEC reports, “criticizing the market complexity they believe is attributable to the maker-taker system.”

“Others have argued that high maker rebates necessitate high offsetting taker fees,” SEC staff suggest, “which may cause some order flow to migrate to non-exchange venues in search of lower transaction costs.”

These potential issues continue to lead to recommendations to study the maker-taker pricing model in greater detail and consider alternative frameworks. Writing on the subject in a recent op-ed for Pensions & Investments, George Michael Gerstein, ERISA counsel at Stradley Ronon, argues in no uncertain terms that the question of “whether broker/dealers’ handling governmental and ERISA plan transactions are satisfying their best execution obligations should matter to plan fiduciaries.” Columnists writing for other publications, including the New York Times, have offered their own takes on the appropriateness of maker-taker fees. Many writers, frankly, have voiced skepticism about the fairness or transparency of the system.

In Gerstein’s article, he suggests liquidity-providing broker/dealers typically do not pass their rebates and fees on to customers. And so “regulators are increasingly worried that investors, retail and institutional alike—including governmental and ERISA plans—are not receiving best execution on their transactions.” The implication is that brokers may be placing their business on platforms that offer greater rebates but not necessarily the best or most timely execution, which would clearly be a violation of the duties of prudence and loyalty.

Plan advisers and other fiduciaries can turn to a variety of sources for guidance here. Best execution, as described in FINRA Notice Regulatory 15-46-c, requires a broker/dealer “to exercise reasonable care to obtain the most advantageous terms for the customer.” That same publication directly prompts investment professionals to “regularly and rigorously examine execution quality likely to be obtained from the different markets trading a security.”