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Debate Over Conflicts of Interest in Equity Markets Rages On

Last week's Senate hearing explored conflicts of interest faced by brokers that receive payment for order flow and rebates for routing orders to certain trading venues, but many experts warned against immediate change.

Last week's Senate hearing put brokers and exchanges on the spot about payment for order flow and maker-taker rebates as practices that are part of high-speed US equity trading.

"Many market participants are worried about the conflicts of interest embedded in the current market structure," said Sen. Carl Levin (D-MI), who heads the panel. He found it hard to believe that the exchanges offering the highest rebate also offer the best price in the market.

During the hearing last Tuesday, Sen. Levin focused on two types of conflicts of interest. The first is when retail brokers receive payment for sending their order flow to a wholesale broker, and the second is when brokers route their orders to an exchange paying the highest rebate. "These brokers argue they can pocket the rebates while still supplying clients with best execution," the senator said, expressing concern that such incentives can interfere with the broker's legal obligation to obtain best execution for the client.

TD Ameritrade was questioned by Levin about its acceptance of payments for customer orders. The online retail broker disclosed that it earned $236 million in 2013 from firms that paid to execute its customers' orders. According to a New York Times article on the hearing, Levin cited data from the fourth quarter of 2012, when Amertitrade routed all non-marketable customer orders -- those that could not be immediately executed at the market price -- to one trading venue. Direct Edge offered the highest rebate during that period.

But the hearing isn't expected to lead to immediate change in the incentives. "Our biggest takeaway from Tuesday's Senate hearing was that the ball is in the SEC's court, and Congress will let the regulator perform its due diligence before forcing changes," Sterne Agee analyst Jason Weyeneth, who covers asset management as well as online brokers, wrote in an email Friday.

Though Sen. Levin's closing comments were stronger in tone, Weyeneth wrote that the majority of the hearing was reasonably benign and focused on the need for disclosure, better transparency, and an even playing field, rather than sweeping changes to market structure. "We expect the SEC to conduct a thoughtful and thorough review of all aspects of market structure before implementing any changes," Weyeneth wrote. Though he didn't dismiss the possibility of payment for order flow going away, he predicted that implementing such a change was down the road. The SEC is planning to look at maker-taker rebates and payment for order flow as part of a sweeping review of market structure that includes requiring HFT firms to register as broker dealers and more disclosures and transparency from dark pools.

What about other distortions?
Meanwhile, market structure experts are concerned that any policy changes to eliminate these incentives could disrupt the liquidity in the stock markets. In new research from Tabb Group, founder and CEO Larry Tabb said the equity market is not distortion-free, but that rebates and maker-taker pricing are not necessarily detrimental for the equities market. "Eliminating rebates runs the risk of reducing the number of exchanges from 11 to 7," he cautioned, implying that, without incentives, volume would decline at certain trading venues and lead to consolidation.

David Weisberger, executive principal of Two Sigma Securities, said during a trading technology panel at the SIFMA Tech 2014 conference that policy changes to the maker-taker pricing model would result in lower trading volume from market makers, and that competition had been good for the markets.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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IvySchmerken
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IvySchmerken,
User Rank: Author
7/2/2014 | 10:36:24 AM
Re: Many things to be decided
If the SEC conducts a comprehensive review of US equity market structure, a significant change would at least take a year. When Reg NMS was first considered, at first there was a proposed rule, public hearings were held, then a public comment period was provided, and then the final rule was published. The effective data of the final rule was Aug. 29. 2005. Implementation for most brokerage firms was delayed until 2006. However, this was a major overhaul. Reg NMS modernized the market structure. It's possible that the next set of changes will be tweaks to Reg NMS and take less time.
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
6/30/2014 | 6:17:16 AM
Re: Many things to be decided
8 months is a little short for a regulator. However, there is growing pressure to address the many issues that face the electronic markets. 1 year might be about right, and I think that is what most people expect to see (some significant moves by the SEC in about 12 months time).
Becca L
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Becca L,
User Rank: Author
6/29/2014 | 11:34:49 PM
Re: Taking time
Oh wow, this is interesting! Thanks for putting that on my radar. It looks like they're testing for more-or-less the same impacts ["Such a pilot should facilitate studies of the effect of tick size on liquidity, execution quality for investors, volatility, market-maker profitability, competition, transparency and institutional ownership," according to the SEC order.] It will be interesting to see how well tests prepare firms for the the real-world if this tick-size program does take off, there are usually a few unforgotten but important details even in the best laid plans.
IvySchmerken
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IvySchmerken,
User Rank: Author
6/29/2014 | 10:52:13 PM
Re: Taking time
The SEC is likely to run pilots for any changes in the market structure. So this is a type of test.  Last week the SEC authorized a one-year "tick size" pilot program for certain stocks. It would let them trade on five cent increments instead of one-penny increments.. The SEC asked the US exchanges and FINRA to work together on a plan to be submitted within 60 days. The idea is that by widening the spreads  brokers would spend more money on research to drum up interest in small cap stocks. [For more information, see http://www.reuters.com/article/2014/06/25/sec-pilotprogram-trading-idUSL4N0P61HV20140625]

 
Becca L
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Becca L,
User Rank: Author
6/29/2014 | 9:39:54 PM
Re: Taking time
I imagine there are (or will be) products on the market that will help all these industry participants make test runs under these conditions before they're deployed. It would be complex, to be sure, but the industry could rally to create the alternate scenario (like Quantum Dawn 2) so they can test preparedness for such a drastic change without having the rug pulled out from under them.
Becca L
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Becca L,
User Rank: Author
6/29/2014 | 9:34:04 PM
Re: Many things to be decided
LOL "thorough review" before making "drastic changes." yeah... I'll tune back in for any developments in... 8 months, maybe 1 year. Or is that overly optimistic?
IvySchmerken
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IvySchmerken,
User Rank: Author
6/27/2014 | 1:53:23 PM
Taking time
The SEC is expected to take the time it needs to thoughtfully review all the issues related to equity market structure. Industry participants would be concerned quick action since the issues are so complex and intertwined.  There are incentives like maker taker, which fuel high frequency tarding, payment for order flow, dark pools, SIP feeds, among others.
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
6/27/2014 | 7:22:37 AM
Many things to be decided
As you mention, there are a lot of factors that need to be addressed before the SEC takes action. I have a feeling it will be a while before the regulators change anything. Hopefully they will do a thorough review before making any drastic changes.
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