Understanding Inverted Exchanges: Impact on Trading & Liquidity

By: Spencer Israel

In their role as market facilitators, exchanges are responsible for ensuring there is enough liquidity for buyers and sellers, and that the pair are matched up efficiently and fairly.

One of the ways they’ve done this is by what’s called a “maker-taker” model, which has been around since 1997.

Exchanges- like the flagship New York Stock Exchange— will then profit on the difference between the fee charged to the taker and rebate paid out to the maker, though both are small. According to Tabb Group Founder Larry Tabb, rebates can range between $0.20-0.32 cents per 100 shares.

The argument for the maker-taker model is that it allows exchanges to reward market participants who create liquidity on their exchanges, which in turn creates more efficient markets. However, others have argued that it incentives brokers to prioritize higher maker-taker fees over trade execution quality.

This is where another alternative comes in: the inverted model.

The Difference Between an Inverted Exchange and Regular Exchange
In an effort to compete in what has become a crowded field, some exchanges have offered an inverted model. On an inverted exchange, such as CBOE EDGA, BATS BYX, or Nasdaq BX, the maker-taker model is flipped to a taker-maker model. In other words:

• Exchanges pay rebates to any broker or market maker that executes a trade against one of those standing bids or asks—as a reward for taking liquidity out of the market.
• Exchanges collect a fee from any broker or market maker that posts open bids and asks on the exchange as a penalty for providing liquidity.

Nasdaq was the first exchange to try this model in 2009, and in the ensuing years most major exchange companies have begun offering inverted exchanges as an alternative pricing model to win new business. In 2017 Intercontinental Exchange—owners of the NYSE—was said to be considering following suit.

Why Inverted Exchanges Matter to You
Though inverted exchanges are smaller than their non-inverted counterparts, they have been gaining in market share over the past decade despite the relatively lower liquidity on these markets.

Why? Because the traders that are participating in the market want those rebates.

This is where you come in. Studies have found that inverted exchanges have become the first venue of choice for retail trades, as retail brokers seek out rebates for their client orders. Only if the order can’t be filled on an inverted exchange will it be routed to a maker-taker exchange.

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