U.S. stock exchanges and one of the world’s largest mutual fund companies called for greater public disclosure or elimination of obscure incentives and fees that lawmakers said favor the interests of high-speed traders over other investors.
Executives from Intercontinental Exchange Inc., owner of the New York Stock Exchange, Bats Global Markets Inc., IEX Group Inc. and Vanguard Group Inc. told the Senate’s Permanent Subcommittee on Investigations that rebate fees and payments to brokers for orders should face greater regulatory scrutiny. High-frequency traders now account for about half of U.S. stock trades.
“We are seeking support for the elimination of maker-taker pricing and the use of rebates,” said Thomas Farley, president of the NYSE Group. “Broad adoption of this policy would reduce the conflicts inherent in such pricing.”
Senator Carl Levin, the Michigan Democrat who leads the panel, called the hearing to examine conflicts of interest embedded deep in the plumbing of equity markets that he said are leading to the erosion of investors’ trust and confidence.
“Conflicts of interest damage investors and markets -- first, by depriving investors of the certainty that brokers are placing the interests of their clients first and foremost, and second, by feeding a growing belief that the markets are simply not fair,” Levin said at the hearing.
Man, Machine and the U.S. Stock Market
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.”
The committee, known for highly-publicized investigations of Wall Street following the 2008 credit crisis, scheduled the hearing amid increasing concern that stock markets and regulators’ ability to oversee them are in need of change. The 2010 flash crash, a series of technological failures and the recent publication of “Flash Boys” have fed scrutiny of high-speed and off-exchange trading.
Eric Schneiderman, the New York attorney general, has subpoenaed high-speed traders including Chopper Trading LLC, Jump Trading LLC and Tower Research Capital LLC as part of a probe into automated trading, a person familiar with the matter said in April. The Securities and Exchange Commission and Commodity Futures Trading Commission are also investigating whether the traders benefit unfairly from better access to data or other incentives.
The SEC, which has been weighing changes to the structure of U.S. equity markets since 2009, is considering its most sweeping plan yet for reining in high-speed trading. The plan would increase registration of proprietary traders and disclosure by brokers and dark pools -- broker-owned venues that compete with traditional exchanges but keep orders hidden until they’re completed.
Enforcing rules for high-frequency trading and alternative trading systems are among the SEC’s priorities, Andrew Ceresney, the commission’s enforcement chief, said today at a Wall Street Journal conference in Washington.
“The markets have changed a lot,” he said. “Algorithmic trading is now obviously the norm in the markets. And the way markets have become much more complex and much more advanced has really focused our attention on this area.”
At the hearing, Joseph Brennan, head of the global equity group at the Vanguard Group Inc., and Joseph Ratterman, chief executive of BATS, also called for greater transparency for how investors’ orders are routed and executed. However, Ratterman said that banning trading incentives would cause harmful disruptions in the market and regulators can properly oversee the industry through additional transparency and enforcement actions.
“While our current equity market structure is not perfect, I believe that it is by far the fairest, most efficient and most liquid market in the world,” Ratterman said.
Online brokers rallied amid the hearings. TD Ameritrade Holding Corp. (AMTD:US) advanced 4.5 percent as of 12:25 p.m. New York time, while E*Trade Financial Corp. (ETFC:US) rose 6.7 percent and Charles Schwab Corp. (SCHW:US) climbed 4.8 percent. Exchange operators saw tamer gains, with Intercontinental Exchange Inc. (ICE:US) adding 0.9 percent and Nasdaq OMX Group (NDAQ:US) Inc. increasing 1.1 percent.
Lawmakers and regulators have previously focused on whether high-frequency firms should register and if off-exchange trading platforms need better disclosure. By contrast, today’s hearing focused on the financial relationships between exchanges, brokers and traders.
Levin specifically questioned a system of incentives between exchanges and high-speed traders known in the industry as “maker-taker.” The system is the predominant way exchanges attract orders from brokers. Traders who are ready to buy or sell shares as needed, known as market makers, are paid rebates by an exchange. Traders on the other side, the “takers,” instead pay a fee.
Most stock exchanges charge about 30 cents per 100 shares to firms that trade against standing buy and sell requests. The exchanges pay less to brokers who supply them with liquidity, and profit off the difference between those fees.
Critics of maker-taker, including ICE Chief Executive Officer Jeffrey Sprecher, say it presents another conflict of interest for brokers who may shop for rebates instead of putting clients first. Other critics say it contributes to the race for speed because many high-frequency traders have employed strategies that involve capturing rebates.
Levin also highlighted a separate system known as “payment for order flow” in which retail brokers such as TD Ameritrade and Charles Schwab Corp. are paid to send client orders to third-party specialists. Those firms, such as Citadel LLC and KCG Holdings Inc. (KCG:US), which profit from taking the other side of the trades, are bound by rules meant to ensure they get the best price possible for investors.
Levin said the payment system creates a conflict because the wholesale broker who offers to pay the most for the order flow may not get the best prices for customers when executing the trades. In his book, Lewis criticized the practice for being designed to maximize the number of times an ordinary trader would collide with a high-speed trader.
TD Ameritrade said in a June 12 statement that it received $236 million in revenue in 2013 for routing orders and said the practice was subject to regulation, oversight and proper disclosure and produces lower, not higher prices, for retail customers.
“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. Best execution comes first,” Steven Quirk, a senior vice president at TD Ameritrade, told the committee.
Senator John McCain of Arizona, the top Republican on the panel, said there is a lack of publicly available data to determine the effect rebate models have on the market.
“A logical first step would be to have more transparency in the payments, allowing neutral researchers to study the issue in greater detail,” McCain said.
The rebate programs and payments for orders are “two concepts that are integral to the way business is done today and have gotten the most scrutiny,” Richard Repetto, exchange analyst at Sandler O’Neill & Partners LP in New York, said yesterday in a telephone interview. “But that doesn’t mean you change them without thought and analysis.”
(Bloomberg LP, parent of Bloomberg News, owns Bloomberg Tradebook, which operates a trading platform for stocks, futures and derivatives. Bloomberg LP also owns a stake in a company, Bids Trading LP, which operates a dark pool.)
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