ETFs making payments to market makers?

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The idea of ETF issuers paying fees to exchanges for market maker support continues to gather steam.

Nasdaq OMX and NYSE ARCA have proposed the idea, and BATS has already implemented such a program. According to Traders, more people on the buy-side are getting comfortable with the idea. The ICI has offered its unqualified support. So has buy-side power BlackRock.

How would this work?

Consider a proposed pilot by the Nasdaq, which would call for issuers to pay up to $100,000 a year to fund payments to market makers. Market makers would only be paid if they can improve execution quality. Participation would require market makers to have at least 500 shares on both sides of the NBBO for 25 percent of the day. They would also be required to post bids and offers no further than 2 percent away from the NBBO for 90 percent of the day, and they would have to ensure that there would be at least 2,500 shares of aggregate bids and 2,500 shares of aggregate offers. Only then will they get paid.

The issue of enhanced liquidity for lightly traded securities has been a vexing problem for years. Nonaccelerated filers have suffered a dearth of stock trading liquidity acutely. And over the years, people have proposed paying for either research or liquidity. My sense is that this is an all-or-nothing proposition for ETFs. If such programs are fully launched, most ETF issuers will have no choice but to pay for the service. If you do not, you face great fears in the market as to the liquidity of your ETFs. It will become a cost of business, which is great news for the exchanges.

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