Firstly, one has to distinguish between maker/taker (M/T) pricing and payment-for-order-flow (PFOF). These two things are often conflated by the media as 'rebates'. They are quite different:
Maker / Taker
The person who posts a bid or ask on the exchange (who is potentially taking more risk) is given a reduction in transaction fee by the exchange for posting, instead of 'taking' (sending an order that interacts with an existing bid).
Usually the fees are structured so that the Taker might pay $0.30 per contract while the Maker receives a rebate of -$0.20. The exchange would in turn receive the difference ($0.10).
This method encourages participation in the book providing depth and adding liquidity to the exchange and competing based on price. In my opinion this is a good practice and good for investors. Depending on the exchange and the broker you use, you the customer will be able to receive the rebate, though this may in turn be consumed by broker fees (but should at least reduce those broker fees depending on your broker's pricing schedule).
Furthermore, M/T typically operates on a price/time priority - the person who added their quote to the book first is the one who gets the trade.
CBOE BATS Options, NASDAQ Options Market, NYSE Arca Options, MIAX Pearl and Boston Options operate with this model.
This is most prevalent in options that are not priced in pennies ($0.01 cent increments) but in nickels ($0.05 cent increments).
Here, instead of an exchange participant differentiating their quote by offering it at a better price, they instead establish a relationship with a broker and through an exchange supported mechanism say to the broker - if you send your flow to us, we will pay you $0.20 per contract. They may privately negotiate rates based on how many 'professional' or 'retail' orders exist in the flow. Retail flow has a higher cost as retail customers are not likely using sophisticated pricing models to price their option orders (and so the trades should be more profitable).
The broker (or order flow provider or consolidator) send their order to the exchange where the participant they have a relationship with trades, and marks on the order that it is destined to that participant. The exchange's "customer priority" matching engine in turn sends most, if not all of that order to the designated participant.
Exchanges that rely on this model often prioritize quotes based on size - the larger the quote you have, the higher percentage of the order you will receive (but with "customer priority" if there is a retail customer order in the book).
The downside to this method is:
- There is little incentive for the exchange participant or market maker to provide more competitive pricing. They just have to match the price with other market makers to be executed against, and pay for the order flow.
- The market maker can deduce additional information from the order flow that was directed at them, such as what direction the professionals think the market is going and what direction retail customers think the market is going.
- the retail customer is paying a premium for their execution costs... it is just baked in to the price so they are paying for it indirectly.
- it encourages a fractured market where orders are directed only to specific market makers, or to certain exchanges.
- because the order flow is being paid for, other firms are effectively paying for the right to have your order directed to them. Who it is sent to and the criteria for those decisions is not public information.
- PFOF market makers or exchange participants would want to discourage non-PFOF firms from participating on the exchange, so might encourage the exchange to increase technology costs and participation fees, or offer volume tier based exchange fees to keep smaller more competitive firms out (saving them from having to match more aggressive prices).
PFOF is often characterized to regulators as "customer priority" as exchanges that offer these PFOF transaction mechanisms often also say that if a retail customer posts an order on the book, it will be given execution priority over other exchange participants (and likely flagged as a retail customer in the market data feed for all to see).
One could argue that if you are a large financial institution, you pounded the pavement to get the customer, so why should the market maker benefit by selling options to customers at less than optimal prices? Getting a rebate through PFOF allows the broker and order consolidator to collect a higher percentage of the trade.
In my opinion, PFOF is corrosive in that it discourages market participants and market makers from competing based on price. While execution standards remain the same (brokers still have to follow the "best execution" standard), the market maker or market participant has to increase the price of his quote to account for the fact that he expects to pay a certain amount for order flow.
PFOF has always been around (since before the markets became electronic), but it may have been only recently where brokers have been able to rely on PFOF sufficiently that they can offer commission free trades. They have previously offered a certain number of commission free trades, and covered the airwaves with advertisements. The ending of the penny pilot program and introduction of more options exchanges (many operated by the same organization) may have paved the way for more PFOF.