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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.

Rebate-pricing schemes are the most controversial at the moment, but Tabb cited a number of other distortions and non-transparent payment mechanisms, including exchange pricing tiers; the development of internalization and ATS platforms; payment for order flow relationships between wholesalers and retail brokers; and soft-dollar relationships where commissions are used by the buy side to receive services from brokers, including trading tools, research, and corporate access. "Each of these mechanisms leverages discrete payment channels to influence the routing of order flow."

Robert Battalio, professor of finance at Notre Dame's Mendoza College of Business, who co-authored a research paper, testified that, when given the choice, four of the largest online brokers (TD Ameritrade, E-Trade, Fidelity, and Scottrade) route orders in a way that focuses on liquidity rebates. "With the marketable stuff, they go to the wholesale brokers, and they always go to the high rebate exchange for the non-marketable orders."

Sen. Ron Johnson (R-WI) weighed in with his own trading example of wanting to buy 100 shares of a $20 stock, insisting that a 30-cent rebate on a $2,000 trade was miniscule. Drawing on his own experience, he said that retail brokers are paying lower prices to trade and have instant access. Government intervention, versus having free-market competition drive transparency, could have unintended consequences, he said.

Ultimately, the ethics of brokers seeking rebates became the focus of debate.

"If you look at the payments, there is a known conflict in the market, and we should address it," said Brad Katsuyama, CEO of IEX Trading. "The size of the conflict relative to the notional traded is not a reason to ignore the conflict." Katsuyama, a proponent of market reforms, was featured in the book Flash Boys, which criticized the routing of retail orders to wholesalers.

In terms of assessing whether going for the highest rebate was harmful to investors, he said, the exchange that pays the highest rebate would have the longest queue. "Where is the seller going to go? The seller is going to avoid the highest [take] fee. So getting in the line for the venue that pays the highest rebate exposes you to more competition and also makes you the least likely venue to get filled at, because the seller of the order is not incentivized to go there."

However, routing decisions that capture the highest rebates are not necessarily bad. Katsuyama said that routing decisions are also conditional upon what's happening in a stock. "There are times when you could be getting the highest rebate and also serving your client's interest."

Joseph Brennan, principal and head of the global equity index group at Vanguard Group, said it didn't accept payment for order flow or rebates to avoid conflicts. Vanguard executes $2 billion of trades a day and spends a lot of time monitoring brokers, he said, so removing maker-taker wouldn't make a difference.

When asked what would happen if he had a less conflicted environment, Brennan said it might make the review process of the data less complex.

As for next steps, Katsuyama said a proposed pilot study of eliminating rebates in certain stocks should be given a chance to prove that maker-taker doesn't harm 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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