Equity market structure issues were aired Tuesday at a hearing by the Senate Permanent Subcommittee on Investigations, the focus of which was conflicts of interest that arise between the obligation of brokers to provide customers with best execution, and brokers’ receipt of payments from other brokers for order flow and rebates from some trading venues for placing those orders directly.
The practices are a direct result of the proliferation of exchanges and other trading venues, such as broker-owned dark pools and crossing networks, that now characterize the U.S. equity markets, according to witnesses representing the buy side, sell side, exchanges, and academia.
What has developed over time, as the different exchanges have implemented different pricing points, is the ability for certain traders to engage in “rebate arbitraging,” said Joseph Brennan, principal and head of global equity index at The Vanguard Group.
“This was not the purpose of this fee/rebate structure,” Brennan said. “More importantly, as the amount of fees and rebates differ across exchanges, it creates the appearance of a potential conflict in which brokers posting liquidity may be motivated to send an order to the exchange that offers the highest rebate, while brokers routing market orders taking liquidity may be motivated to send their orders to the exchange that charges the lowest fee.”
Brennan also took aim at dark pools, recommending that a “trade-at” rule be adopted that would require venues that do not contribute to the price discovery process to provide mandatory price improvement over publicly-displayed prices. Such a rule has been adopted in Canada and Australia, and is being considered by the Securities and Exchange Commission.
Tom Farley, president of IntercontinentalExchange's NYSE Group, said that New York Stock Exchange was imposing a six-month moratorium on new order types that further segment the market. “We believe that this will give the industry and the SEC time to focus on the complexity that exists,” he said. “In addition, we have already announced the elimination of more than a dozen unique order types.”
NYSE is seeking support for the elimination of maker-taker pricing and the use of rebates. Broad adoption of this policy would reduce the conflicts inherent in such pricing schemes and further reduce complexity through fewer order types and fewer venues, Farley said.
Farley also advocated the adoption of a trade-at rule. “In conjunction with the elimination of maker-taker and rebates, we believe regulation should require that deference be given to displayed quotes,” he said. “There is risk involved in displaying a quote accessible to all market participants and we believe strongly that the person taking that risk should be rewarded with an execution at that price.”
Robert Battalio, professor at the Mendoza College of Business of the University of Notre Dame, recommended enforcement of current best execution requirements on brokers. “Requiring that brokers rigorously demonstrate that their routing practices insure best execution for their clients on a regular basis would be a good first step before initiating additional regulations,” he said.
Battalio cited research performed by him and his colleagues which analyzed Rule 606 filings to conclude that four retail brokers made order routing decisions in the fourth quarter of 2012 that appear to maximize the liquidity rebates generated from limit order executions. Specifically, these brokers appear to route their customers’ standing limit orders to a single exchange that pays the maximum liquidity rebate, Battalio said.
Steven Quirk, senior vice president, trader group at TD Ameritrade--one of the four brokers cited by Battalio--questioned Battalio’s empirical methods, stating that the study used two months of data consisting of non-retail order flow from one broker trading algorithm. “We question whether it is appropriate to draw any conclusions about the execution quality of retail order flow, which appears to us to be fundamentally different from the order flow that was analyzed,” Quirk said.
Featured image via Dollar Photo Club
