Lawmakers waded into the debate over the U.S. stock market’s fairness today, going beyond the usual flashpoint of high-frequency trading to focus on potential conflicts of interest among brokers.
Senators led by Carl Levin grilled brokerage and stock-market executives at a hearing over the various incentives that underpin U.S. equity trading, including rebates exchanges use to lure volume, and the payments market-making firms such Citadel LLC and Citigroup Inc. give retail brokers.
The inquiry is the latest to examine features of the fragmented American equity market where computers have supplanted floor traders and 11 exchanges compete for investors’ orders. While U.S. Securities and Exchange Commission Chairman Mary Jo White said this month that the market “is not fundamentally broken,” Levin said Congress may have to get involved to address conflicts of interest.
“The current structure gives brokers an incentive to place their own interests ahead of the interests of their clients,” Levin, a Democrat from Michigan, said in his opening remarks. “The party making the decision should only be influenced by the best interest of the investor –- that’s what ethics demands, and it’s what the law requires.”
TD Ameritrade Holding Corp., one of the biggest online brokers, last week gave an inkling of the money involved. The Omaha, Nebraska-based firm revealed that it pocketed $236 million in 2013 from firms that paid to execute its customers’ orders.
While testimony about online brokers swirled, their shares rallied. TD Ameritrade advanced 4.8 percent at 3:24 p.m. New York time, while E*Trade Financial Corp. rose 7.7 percent and Charles Schwab Corp. climbed 5.4 percent.
“The payments we receive from market participants do not interfere with our efforts to seek quality execution and optimize the value proposition for our clients,” Steven Quirk, a senior vice president at TD Ameritrade, told the committee today. “Best execution comes first.”
Today’s hearing of the Senate’s Permanent Subcommittee on Investigations focused on how brokers and exchanges interact with individual investors and mostly steered clear of high-frequency trading, the light-speed buying and selling that previously earned much of the criticism. Instead, Levin focused on firms entrusted with orders to buy and sell stock. While they have an obligation to find the best price, they seem to be swayed by something else, he said.
‘Hard to Believe’
“While they make a subjective judgment as to which trading venue provides best execution, tens of millions of trades a year, that subjective judgment always just happens to also result in the biggest payment to brokers,” he said. “I find it hard to believe that this is just a coincidence.”
Executives from New York Stock Exchange owner Intercontinental Exchange Inc., Bats Global Markets Inc., IEX Group Inc. and Vanguard Group Inc. told the panel that rebate fees and payments to brokers for orders should face greater regulatory scrutiny.
“We are seeking support for the elimination of maker-taker pricing and the use of rebates,” said Thomas Farley, president of ICE’s NYSE Group. “Broad adoption of this policy would reduce the conflicts inherent in such pricing.”
Brad Katsuyama, president and chief executive of IEX, and Robert Battalio, professor at the University of Notre Dame, told the committee that the government should consider forcing greater transparency of market data and incentives.
“There’s been no attempt by the market to solve this issue,” said Katsuyama, a central character in Michael Lewis’s bestselling book “Flash Boys” for his efforts to limit predatory trading strategies. “Therefore the government would be very helpful in helping the industry to coordinate.”
In April, three people familiar with the matter told Bloomberg News that the SEC was weighing a proposal to require brokers to tell investors exactly where they send orders, potentially giving more insight into whether they’re getting the best prices. Weeks later, SEC Chairman White voiced concerns about broker incentives.
“When fees and payments are not passed through from brokers to customers, they can create conflicts of interest and raise serious questions about whether such conflicts can be effectively managed,” White said in the June 5 speech at an industry conference.
Larry Tabb, CEO of Tabb Group LLC, estimates that retail orders that are sent to market-makers and executed away from exchanges account for 15 percent of total U.S. volume. He doesn’t anticipate that the SEC will take any imminent action to limit the practice.
“The SEC has determined that they want to provide a better execution environment for retail investors,” Tabb said by phone. “They’ve allowed payment for order flow and they don’t force all of the order flow into one central environment.”
Under the payment for order flow system, online brokers agree to send their customers’ trades to specific securities firms for execution. These wholesalers include Citadel, KCG Holdings Inc. and Citigroup.
Tabb said among the benefits of selling customer orders are that online brokers don’t need to set up their own trading desks. The payment system also keeps relationships above-board, he said, though the regulator “could do a better job in terms of forcing greater transparency,” he said.
While supporters say trading has never been better for retail investors, some critics say payment for retail orders needs to be changed because it keeps so much trading in the dark. The system keeps some trades off public markets, harming the price discovery process by keeping some buying and selling interest hidden, said Thomas Peterffy, chairman of Interactive Brokers Group Inc.
“If we want brokers to fulfill their fiduciary duty with respect to getting the best price for their customers’ orders, than payment for order flow must be eliminated,” Peterffy wrote in a June 15 e-mail.
The Senate hearing’s focus on paying for orders will bring the practice into the spotlight, said Howard Schiffman, Washington-based partner at law firm Schulte Roth & Zabel LLP.
“The challenge for brokers like TD Ameritrade will be to make a case that this is in the best interest of their customers,” he said.
Levin closed the day’s hearings with a call for next steps.
“We’ve got to rid our market of conflicts of interest to the extent that it’s humanly possible if we’re going to restore confidence in our markets,” he said. “Hopefully the regulatory agencies are going to take action.”