Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer was a US senator and chaired the Senate subcommittee on investigations
With a new administration incoming in Washington, it is time to end a conflicted practice that siphons billions out of US investors’ funds each year.
The Securities and Exchange Commission needs to stop brokers from accepting payments for routing their customers’ orders to certain traders and exchanges. It is like paying a hidden, private tax on savings whether someone invests through a large mutual fund or directly through a personal brokerage account.
Here’s how it works. When an investor buys or sells stocks or other securities, the investor typically turns to a broker for help. That broker is the investor’s agent. His job by law is to get the investor the “best execution”, which generally means the best available price.
With more than a dozen exchanges and scores of off-exchange trading venues to check, this process is complex. It also operates at great speed. The difference for an investor between getting the best available price and something worse can be decided in nanoseconds.
Rather than check multiple trading venues for the best prices, many brokers instead contract in advance to sell their customers’ orders for a fee, and then pocket the fee for themselves. These fees are called “order routing incentives”.
And the “incentives” for brokers can add up quickly. During the second quarter of 2020, for just Schwab and TD Ameritrade, these payments totalled over $390m. Given the size of these payments, investors may want to ask whether their brokers are really routing orders to get them the best prices. It seems likely that brokers may be instead seeking just the biggest payments for themselves.
The biggest payers are usually ultra-high-speed trading firms and exchanges. They have figured out that, on average, they can pay brokers for customer orders and still make a profit. But how?
First, the high-speed trader needs to know what the prices are at all major venues. So it buys expensive market data delivered at lightning speeds. Second, it needs to be able to take in data, process it, and trade in fractions of a second. Then it needs to trade.
To make sure that it has a stream of opportunities to buy low and sell high, the firm will pay millions to brokers, just to have the opportunity to trade against those brokers’ customers. Lastly, in order to appear to satisfy the best execution requirements, the high-speed trader will offer “price improvement” to the customers whose orders are being routed.
Yet despite all these costs for data, infrastructure, and offering “price improvement” to customers, these traders still turn a significant profit. It can only happen if the traders are getting better prices than they are providing the brokers’ customers. But if that is the case, what about the brokers’ best execution obligations?
The Financial Industry Regulatory Authority, which regulates brokers, has examined order routing practices and offered some guidance calling into question the propriety of payment for order flow. But Finra has never fundamentally challenged this deeply conflicted practice. Neither has the Securities and Exchange Commission.
A few weeks ago, Silicon Valley-based retail broker Robinhood agreed to pay $65m to settle SEC charges that it failed to ensure its customers were getting best execution. The regulator said the company failed to disclose payments it received from high-speed trading houses. That followed a settlement with Finra several months earlier for not fulfilling its best execution obligations. The brokerage has said in a statement that the practices under scrutiny in the settlement did “not reflect Robinhood today”.
But even with this settlement, regulators have again permitted brokers to keep accepting payments for routing their customers orders.
Essentially the same conflict harms even the world’s largest investors. For nearly a decade, several large investors pleaded with the SEC to require brokers to make better disclosures, and to implement a pilot program that would prohibit brokers from taking these payments.
In 2018, the SEC revised its rules on broker disclosures and even adopted a pilot programme to implement a ban on the payment of these incentives.
Unfortunately, the disclosures do not provide investors with hard data to consistently see how their orders are routed. And worse, a federal appeals court blocked the SEC’s pilot programme last June.
Millions of American families and businesses are still paying the price for their brokers’ conflicts of interest. I hope President Joe Biden’s SEC will take simple action to protect investors by ending the practice of accepting payments for routing customers’ orders.