Market fragmentation has led to a “crisis of trust” among investors that U.S. regulators could help remedy by forcing broker-dealers to send orders to public exchanges, said Thomas Peterffy, chairman and chief executive officer of Interactive Brokers Group Inc.
Internalization, as the process of handling orders in-house is called, risks making the prices on exchanges less reliable, he told an audience of regulators and bourses at the World Federation of Exchanges annual meeting in Paris today.
“To the public, the financial markets may increasingly seem like a casino except that the casino is more transparent and simpler to understand,” said Peterffy, one of the earliest advocates of using technology to improve the efficiency of trading on exchanges. “Just as the emerging markets led by the BRICs are doing a wonderful job establishing their market economies with their exchanges as their centerpieces, we have a crisis of trust in the developed world.”
Rules and technology that allow brokers to compete electronically with exchanges and the rise of high-frequency trading, in which firms use automated systems to transact thousands of buy and sell orders a second, have put pressure on market makers such as Interactive Brokers. These firms must meet obligations to provide public quotations for investors that rival brokers and traders don’t face. Peterffy said in September that his Greenwich, Connecticut-based firm may withdraw from official market making in some options on U.S. exchanges.
‘Why Should They?’
“It is not so much anymore that the public does not trust their brokers,” Peterffy said in a speech today. “They do not trust the markets, the exchanges or the regulators either. And why should they, given our showing in the past few years?”
The practice of brokers internalizing orders from customers prevents buying and selling demand from coming together to produce the fairest prices, he said. Discount brokers send orders to firms that internalize them to avoid fees on exchanges and benefit from payments made by those companies, Peterffy added. Discount brokers say the fees lower trading commissions they charge retail customers. The firms usually get better prices for customers through internalizing brokers than they could receive on exchanges, where official market makers compete with high-frequency traders.
“Exchanges must be able to convince their governments, their regulators and the public that open competition among bidders will result in a better price than no competition, and that the more orders that go to the exchange, the more competition there will be,” Peterffy said. Market makers should also have advantages over high-frequency traders, he said.
In the U.S. almost a third of volume in stocks and exchange-traded funds takes place off exchanges, according to data compiled by Bats Global Markets, an exchange operator in Kansas City, Missouri.
The internalization of orders from individual investors isn’t new. The SEC has tried since at least the 1990s to pare back the payments discount brokers get by shrinking the amount market makers are able to pay for orders without suppressing competition. In a recent paper, two former regulators said customers may benefit when orders transact at venues that aren’t public exchanges.
Robert Colby and Erik Sirri described internalization in a paper published in April as an effort by market makers to segment the types of orders they interact with to reduce the risk of trading with parties that are better informed, which could hurt their profitability. Mutual funds and other institutions also seek trades in dark pools, or private venues that don’t display prices, to avoid information about their buy or sell interest leaking to other market participants, they said in their paper in Capital Markets Law Journal.
“Even though it benefits investors collectively that their orders all meet to interact, particular investors may see advantages in executing their orders outside of a single consolidated market,” they wrote. Colby joined law firm Davis Polk & Wardwell LLP as a partner in 2009 after a decade and a half at the SEC, most recently as deputy director of the commission’s division of trading and markets. Sirri, a finance professor at Babson College in Babson Park, Massachusetts, was that division’s director from 2006 until 2009.
Competition between markets has also made it tougher for brokers to get the best executions possible for their clients, Peterffy said. Discount brokers in the U.S. send most market orders, or requests to trade at the best price immediately available, to brokers that internalize orders.
‘Too Many Exchanges’
“Having too many exchanges creates difficulties for brokers and regulators and undermines the very purpose of an exchange,” Peterffy said. Connecting to multiple markets and deciding where to send orders is an expensive and complex process for brokers that depends on “who the order belongs to and how much each exchange charges or rebates for what product and for what kind of order,” he said.
Many U.S. and European stock exchanges pay those providing buy and sell requests for investors to trade with and charge firms that execute against those orders, pocketing the difference between the rebate and fee. Options venues employ different rules that sometimes allow customers to trade for free and sometimes charge or rebate those using the market. Some exchanges have tiered pricing based on volume or fees that depend on the type of product traded.
SEC Chairman Mary Schapiro has said the agency will consider updating the statistics and data brokers must collect and publish quarterly about where they send orders, as well as the information exchanges provide monthly about the executions on their platforms.
“Customers would benefit from better enforcement of best execution and the SEC should look into it,” Peterffy said in an interview after his speech.
While competition in stocks and options has increased, there are now too many exchanges, Peterffy said today. The U.S. has 12 stock exchanges and eight options markets, with one more of each planned for this month.
“If there are fewer than three exchanges in a given product space, the entrance of more should be encouraged,” he said. “But when we get to five or six, some consolidation should be in order.”
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