A New York senator is lobbying the SEC to reform the maker-taker pricing model, but his proposed solution to potential conflicts of interest is struggling for support.
Democrat Charles Schumer has written a letter to Securities and Exchange Commission (SEC) chair Mary Shapiro imploring her to address when he sees as a “major conflict of interest in securities trading” that may be costing investors up to US$5 billion per year.
The study, called ‘US equity exchange performance 2011’, states differences in exchange performance are rarely considered by smart order routers that direct trades to the multiple venues that trade US stocks.
Matt Samelson, principal at capital markets consultancy Woodbine Associates, said the maker-taker pricing system was causing brokers to make routing decisions often not in the investors’ best interest. He urged money managers to take ownership of where their orders are executed, rather than rely on brokers.
Putting clients first
Senator Schumer called on the SEC to require rebates and other incentive payments be passed on to investors and fully disclosed. The senator said he would consider introducing legislation to mandate all such rebates be passed on to customers if the SEC failed to act.
“In the years following the financial crisis of 2008 and the flash crash of 2010, investors are already questioning the integrity of our markets,” wrote Senator Schumer. “It’s more important than ever to ensure that brokers put their clients first, and not pocket hidden rebates at the expense of their customers.”
The senator believed there should be no incentive for traders “to profit at the expense of their investors”. He said the SEC should make brokers pass on any payments they receive from trading venues to their customers and fully disclose any potential conflicts they may face in routing customer trades.
Woodbine’s study shows maker-taker and payment-for-order-flow create conflicts of interest because brokers are incentivised to execute trades on a venue even if it isn’t offering the best price. It also shows customers have lost up to $5 billion as a result of “sub-optimal order routing decisions”.
“I respectfully urge the Commission to act as promptly as possible to ensure complete disclosure of all such payments and require brokers to pass these payments on to their customers, thus eliminating the potential for conflicts of interest,” wrote Schumer. “Some disclosure is currently required, but it is not sufficient to ensure that customers are fully-informed about the payments received, and routing decisions made, by their brokers. If the Commission does not act, I will consider introducing legislation to address this problem.”
Samelson said Woodbine had been aware of Schumer’s letter but had not spoken with the senator’s office except to say the firm was happy to speak with his office further, should they wish to do so.
“I don’t believe the senator’s letter calls for a ban as much as to fix the issue,” said Samelson. “I think there are several steps the industry and/or regulators could do before taking the extreme step of banning this pricing.”
For instance, Samelson said regulators could require exchange fees were passed on to security principals.
“This might go a long way to removing this particular conflict, but it may cause other micro-structure related issues,” he said. “Additionally, the regulators could mandate more precise reporting or better record-keeping with respect to order handling, and greater still transparency into brokers where client order handling is concerned.”
Writing in their joint blog Sal Arnuk and Joseph Saluzzi, co-founders of institutional brokerage Themis Trading praised Schumer for highlighting the issue, but asserted that his solution did not address the underlying issue of high-frequency trading (HFT) firms practicing ‘rebate arbitrage’. “Proprietary high-frequency traders currently enjoy getting paid up to 1/3 of a penny per share to ‘add liquidity’ in stocks like Bank of America. These rebates have skewed asset prices and are responsible for countless artificial arbitrage trades. Rebates are used as an enticement by the exchanges to lure HFT clients to their exchange so that they could increase their market share and sell other market data related products,” the said.
Themis called instead the maker/taker model to be replaced by a flat fee of 1/10 of a penny per share when adding or taking liquidity. “This fee should offset any revenues that the exchanges would be losing with the elimination of the maker/taker model. By adopting a flat fee model, the problem of fragmentation may finally start to get addressed,” the added.
The SEC has not commented publicly on Senator Schumer’s letter.