Massachusetts Is Probing a Cornerstone of U.S. Stock Trading

Updated on
  • State sent letters to Morgan Stanley, Fidelity, among others
  • Rebates have been long-standing but controversial practice

The state of Massachusetts wants to know whether investors are getting ripped off because their brokers are paid to send orders to U.S. stock exchanges, a practice that drives much of the trading in the $27 trillion market.

Secretary of the Commonwealth William Galvin said Tuesday that he’s examining these incentive payments -- he called them “kickbacks” -- to see if they create conflicts of interest, resulting in investors’ orders not being executed in the best way possible. He sent letters to brokers including Charles Schwab Corp., Fidelity Brokerage Services LLC and Morgan Stanley.

Galvin’s statement echoed a July op-ed in the New York Times written by two Yale University officials, law professor Jonathan Macey and Chief Investment Officer David Swensen, who argued these rebates hurt investors and generate “ill-gotten gains for brokers.” It also resurrected arguments from the 2014 Michael Lewis book “Flash Boys,” which also attacked the practice.

“If financial rebates or kickbacks create a conflict that results in less than the best deal for the investors, this practice must stop,” Galvin said in the statement.

These rebates originated in the 1990s, when an upstart electronic market called Island ECN started paying them to grow its business. It needed a deep order book, so it incentivized market makers to place standing orders investors could trade against. From there, it spread to most U.S. stock exchanges. One notable exception is the Investors Exchange, whose founders were profiled in “Flash Boys.”

SEC Panel

Former Securities and Exchange Commission Chair Mary Jo White once questioned whether the system created conflicts of interest. A panel advising the SEC has recommended a test that would, among other things, examine the impact rebates have on order routing practices.

“We are in the process of reviewing the letter,” Schwab said in a statement. “That said, Schwab takes its responsibility to provide clients with best trade execution very seriously and has a strong track record of meeting those obligations.”

“We are still reviewing the inquiry and it’s too early to comment,” said Stephen Austin, a Fidelity spokesman.

Morgan Stanley didn’t immediately return a request for comment.

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