Nasdaq, the second-largest U.S. stock exchange, is looking to implement a program that would reward with financial incentives market makers who are willing to “go the extra mile” to keep ETF trading spreads tight and ensuring the funds’ liquidity.

In paperwork filed with U.S. regulators, the exchange is asking for exemptions from FINRA’s rule 5250—also known as NASD’s Rule 2460—that prohibit fund sponsors from paying someone to act as a market maker on its behalf. The rationale of 2460 is that market makers should do their jobs without the influence of an extra paycheck.

Nasdaq’s proposal aims to achieve what Rule 2460 prohibits; namely, allow ETF sponsors to pay market makers for helping their funds, especially smaller and newer ones that often need a helping hand to thrive. Market makers make their money by profiting from spreads between bid and ask prices.

Nasdaq’s latest petition—its first two were rejected by regulators—is part of a broad move among exchanges to give market makers incentives to keep trade smooth in certain securities. The Nasdaq plan would involve payments ranging from $50,000 to $100,000 per security per year involved in the program.

The Kansas City, Mo.-based BATS exchange, for instance, launched an incentive program in February, though BATS, not fund sponsors, is the one paying market makers. Even the NYSE Arca platform offers an incentive to lead market makers in the form of rebates per shares, according to information on the exchange’s website.

The heart of the matter is a lack of liquidity in most of the 1,400-plus U.S.-listed ETFs. In the decentralized electronic trading system that prevails in today’s markets, market makers have little reason to ensure tight bid/ask spreads and to generally keep trade in the majority of funds going smoothly when markets turn choppy.

What a market without market makers looks like was abundantly clear during the “flash crash” of May 6, 2010. On that day, which began with the market on tenterhooks as Greeks rioted in the streets of Athens, the stock market became unhinged, and market makers largely ran for cover as the market plunged.

The Dow Jones industrial average dropped 10 percent, only to retrace most of those losses—all in about 30 minutes. It ended up closing 4 percent lower and, crucially, about two-thirds of the securities that ended up having canceled trades that day were ETFs.

Addressing A Problem

That event triggered a regulatory debate on the role market makers play in a world of electronically driven, high-frequency trading and raised the question of whether market makers should be rewarded for providing liquidity and keeping buy and sell quotes close to the market in the ETF space.

“ETFs are priced and traded differently compared to common stock, but are forced to trade by the same rules,” Richard Keary, principal at Global ETF Advisors, said in a telephone interview. “It’s like trying to put a square peg into a round hole.”

Long a proponent of revising trading rules for ETFs, Keary argues that addressing the problem of liquidity and narrow spreads is the right thing to do, even if only a “very small step” in the right direction.

Nasdaq, and BATS for that matter, seems to agree.

Nasdaq said in its filing with the Securities and Exchange Commission that the incentive program should trigger a chain of benefits that begins at the ETF level, where liquidity and narrower bid/ask spreads should help market makers lower transaction costs.

That, in turn, will make those ETFs more attractive to investors, and ultimately will end up helping companies gain access to capital for investment and growth.

The filing goes as far to say that the incentive program would, in the end, make for better markets and would help out the economy.

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