HFT Chapter 3: U.S. Senate To Hear About Payment-For-Order-Flow, Conflicts of Interest and Best Execution

MarketsMuse Editor Note: Finally, the topic of payment for order flow, the questionable practice in which large brokerage firms literally sell their customers’ orders to “preferenced liquidity providers”, who in turn execute those orders by trading against those customers orders ( using arbitrage strategies that effectively guarantee a trading profit with no risk) will now be scrutinized by the U.S. Senate Permanent Subcommittee on Investigations in hearings scheduled for this morning.

The first paragraph of this morning’s NY Times story by William Alden regarding today’s Senate hearings frames the issue nicely: “..To the average investor with a brokerage account, the process of buying and selling shares of stock seems straightforward. But the back end of these systems, governing how billions of shares are traded, remains opaque to many customers…Behind the sleek trading interfaces of brokerage firms like TD Ameritrade, Charles Schwab and Merrill Lynch lie a web of business relationships with relatively obscure firms that make trades happen..”

MarketsMuse has spotlighted this issue repeatedly over the past several years, including citing long-time trading industry veterans who have lamented (albeit anonymously) that the notion of selling customer orders is a practice that not only reeks of conflict of interest, it is an anathema to those who embrace the concept of best execution. Their request for anonymity has been driven less by “not authorized to speak on behalf of the firm” and more by a common fear of “being put in the penalty box” by large retail brokerage firms who embrace the practice of double-dipping (charging a commission to a customer while also receiving a kickback from designated liquidity providers) simply because these firm deliver the bulk of orders to Wall Street trading desks for execution.

Throughout the same period that this publication has profiled the topic, we have repeatedly encouraged leading business news journalists from major outlets to bring this story to the forefront. In every instance other than one, journalists and editors have suggested the topic is “too complex for our readers” and many have indicated that its a story that their “major advertisers (the industry’s largest retail brokerage firms and ‘custodians’) would be offended by.”

NY Times reporter William Alden described the issue in a manner that is perfectly clear and simple to comprehend; whether the issue of “conflict of interest” is clear enough or simple enough for U.S. Senators to grasp is a completely different story.

The following extracts from Alden’s reporting summarize the issue brilliantly; link to the full article is below:

“…But while Ms. White’s proposals were broad in their scope, touching high-frequency trading and the strength of the market’s structure, the Senate panel on Tuesday plans to zero in on the question of fairness. The panel, which is led by Senator Carl Levin, Democrat of Michigan, will examine a payment system that has become endemic on Wall Street, though it is little known outside the world of high finance.

Brokerage firms have a regulatory obligation to give their customers the best possible terms when executing their stock orders. The execution process frequently involves routing the orders to an exchange or a trading firm that can find a match and consummate the order.

But the brokerage firms do not give away their customers’ orders. In many cases, they accept fees or rebates from trading firms or exchanges that receive the orders, under arrangements called “payment for order flow” and the “maker-taker” pricing model. The question before the Senate panel is whether the payments compromise the duty of the brokerage firms to serve their customers.

Brokers that route orders to the venues with the highest fees “may not be obtaining best execution for their clients,” Robert H. Battalio, a professor of finance at the University of Notre Dame, will say on Tuesday, according to a copy of his prepared remarks.

Citing academic research, he plans to say: “Our results suggest that the decision to use a single venue that offers the highest liquidity rebates is not consistent with the objective of obtaining best execution for customer limit orders.”

William Alden’s NY Times article can be found here.