Regulators Plan Investigation of U.S. Stock Brokerage IncentivesSam Mamudi and Dave Michaels
Securities regulators are examining how brokerages decide where to send U.S. stock trades amid concern that routing practices are being driven by self-interest rather than what’s best for clients.
The Financial Industry Regulatory Authority anticipates sending some brokers a questionnaire during the first half of 2014, seeking clarity on their process for picking among the more than 50 venues where American shares trade, said Thomas Gira, executive vice president of market regulation at Finra.
The exchanges and alternative venues that constitute the $22 trillion U.S. equity market offer an array of pricing schedules and order types to lure business from traders. Brokers routinely send orders to whatever market pays the most, prioritizing their own profits over getting the best prices for their customers, according to a recent study from the University of Notre Dame and Indiana University.
Finra will “probably do some type of a sweep, and make sure firms are asking the right questions and looking at the right numbers and doing the right analysis when they’re making routing decisions,” Gira said during an interview yesterday. The self-regulatory organization, which oversees its broker-dealer members, wants to ensure that “they’re not making decisions to put the rebate ahead of the execution quality,” he said.
The group usually sends questionnaires after noticing problems during regular examinations or following high-profile failures. Finra last sent targeted examination letters in July, when it probed automated strategies used by high-frequency traders.
The system of charging brokers who place orders while paying the trades who fulfill the transactions, a model known in the industry as maker-taker, is common in the U.S. and elsewhere after market making by humans became less profitable over the last decade.
The Securities and Exchange Commission squeezed trading profits in 2001 by cutting the minimum price increment for U.S. shares to 1 cent, down from eighths or sixteenths of a dollar, reducing spreads for market makers. Exchanges started paying to encourage electronic trading firms to provide standing orders to buy and sell.
“We are looking closely at best-execution decisions in the very fragmented world of the equities side, particularly with regard to limit orders placed with exchanges that may impose significant maker-taker fees,” Richard Ketchum, chairman and chief executive officer of Finra, said during an interview.
Brokers send equity orders to markets that pay the most for the trades, according to research from Robert Battalio and Shane Corwin of the University of Notre Dame and Robert Jennings of Indiana University.
“The decision to use a single venue that offers the highest liquidity rebates does not appear to be consistent with the objective of obtaining best execution,” the researchers concluded in a draft of their report dated Dec. 13.
Some trading firms are critical of maker-taker. RBC Capital Markets, a unit of Toronto-based Royal Bank of Canada, sent a letter to the SEC in November calling on the regulator to ban the practice of charging some traders while paying others, saying the system causes brokers to send transactions in a way that may be cost effective for them.
A top executive of one of the biggest trading firms, Virtu Financial LLC, told Bloomberg News that he’d like the SEC to reduce the fees exchanges charge traders, effectively curbing the rebates, too.
While these pricing systems probably can’t be dismantled, there are “things you can regulate to mitigate their impact on market structure,” said Chris Concannon, an executive vice president at Virtu Financial in New York. His firm provides offers to buy and sell securities on the New York Stock Exchange and dozens of other venues globally.