For the U.S. stock market’s biggest players, the writing on the wall is getting easier to read.
Executives from exchange operators and fund companies are starting to join lawmakers and regulators in warning that the world’s largest equities market is beset with conflicts that can harm investors and undermine confidence.
Support for a solution increased yesterday at a hearing led by Senator Carl Levin as representatives from New York Stock Exchange owner Intercontinental Exchange Inc. (ICE:US), IEX Group Inc. and Vanguard Group Inc. said trading rebates and payments to brokers for investor trades warrant greater government scrutiny. The systems, embedded in market plumbing over the last two decades, were cited as one of the reasons high-frequency firms now account for about half of volume.
“Hopefully the regulatory agencies are going to take action,” Levin, a Michigan Democrat, said at the end of the half-day hearing of the Senate’s Permanent Subcommittee on Investigations. “There are steps which must be taken either by regulators or by Congress to deal with conflicts and to deal with the other kinds of problems which exist in the current market, because it’s clear there can be improvements.”
Thomas Farley, president of ICE’s NYSE Group, called for the elimination of the rebate system known as maker-taker, saying an outright ban would reduce conflicts and complexity in the market that are discouraging investors from trading.
“Markets rely on confidence; we can’t say that enough,” Farley said at the hearing. “Irrespective of whether or not there’s an actual conflict or a conflict that’s resulting in some sort of bad behavior, the appearance of conflict matters.”
The congressional committee, known for highly publicized investigations of Wall Street following the 2008 credit crisis, scheduled the hearing amid 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 publication of “Flash Boys” by author Michael Lewis have fed scrutiny of high-speed and off-exchange trading.
Man, Machine and the U.S. Stock Market
Yesterday’s review was the latest public pillorying of the American equity market where computers have supplanted floor traders, and 11 exchanges and dozens of alternative electronic venues compete for investors’ orders.
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 U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission are also investigating whether the traders benefit unfairly from better access to data.
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, Mary Jo White, the agency’s chair, said in a speech on June 5. Her 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.
Yesterday’s hearing focused on potential conflicts of interest among brokers and mostly steered clear of high-frequency traders. Senators led by Levin grilled brokerages and stock-market executives 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. (C:US) give retail brokers.
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. “Slightly” less than half of that is for equities, according to Kim Hillyer, a spokeswoman.
Levin specifically questioned incentives between exchanges and high-speed traders, which is now the predominant way markets attract orders from brokers. Traders who are ready to buy or sell shares as needed, known as market makers, are paid 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. At yesterday’s hearing, Bats Global Markets Inc. Chief Executive Officer Joseph Ratterman said his exchange’s cut is about 2 cents per 100 shares.
Critics of maker-taker, including ICE CEO 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.
The hearing 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 specialists. Those third parties, such as Citadel 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 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 June 12 that the payments it receives for routing orders are 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,” Steven Quirk, a senior vice president at TD Ameritrade, told the committee yesterday. “Best execution comes first.”
When asked by Levin whether TD Ameritrade “virtually always” sends client trades to the venue that pays the highest incentive, Quick said that was indeed the case.
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.”
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 “Flash Boys” for his efforts to limit predatory trading strategies. “Therefore the government would be very helpful in helping the industry to coordinate.”
White said earlier this month that she asked the SEC’s staff to recommend a rule to improve disclosure of customer-specific information about how orders are routed.
“A rule is necessary to ensure that the disclosed information is useful, reliable, and uniformly available on request to all institutional customers,” White said in the June 5 speech at an industry conference. “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.”
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 transactions 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. (IBKR:US)
“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.
(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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