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Senate Committee Discusses Payments for Order Flow

On June 17, 2014, the Senate Permanent Subcommittee on Investigations, chaired by Senator Carl Levin (D-MI) held a hearing entitled “Conflicts of Interest, Investor Loss of Confidence and High Speed Trading in US Stock Markets.”  The hearing focused both on conflicts of interest in trading venues, and the impact on markets of high frequency trading.  This post will cover the discussion of conflicts of interest in trading venues as a result of payments for certain types of trades. 

The lead-off witness was Robert Battalio, a professor of Finance at the University of Notre Dame.  Professor Battalio has published a paper that examines the impact on order routing of so-called “maker-taker rebates,” which are payments for executed orders to buy or sell stock on an exchange.  The paper found that some brokerages routinely route retail customer limit orders to venues offering the highest payments for certain types of trades.  Battalio testified that in his opinion, routing orders with a goal of maximizing trading rebates has a negative impact on execution quality.  For example, research suggests that venues offering the highest rebates may have lower “fill” rates (meaning, the percentage of times that orders are executed at the price requested).  Battalio has concluded that a decision to use a single trading venue that offers the highest liquidity rebates may not be consistent with best execution responsibilities of brokers.

During the hearing, Senator Levin repeatedly pressed witnesses on whether maker-taker rebates are consistent with best execution, and whether they represent an unmanageable conflict of interest with customers.  Joe Ratterman, the CEO of BATS Global Markets (an alternative trading system), testified that maker-taker pricing provides an effective incentive to encourage liquidity providers to post offers in the marketplace.  Any potential conflict of interest, he testified, can be dealt with through increased disclosure.  In contrast, Thomas Farley, President of the New York Stock Exchange, testified that the regulations and structures in place incentivize participants to make the US equities markets “more complex and more opaque.”  In order to reduce that complexity and because of the conflicts inherent in what he termed "pricing schema," his organization supports the complete elimination of maker-taker pricing and the use of rebates.

Joseph Brennan, Principal and Head of Global Equity Index Group at Vanguard, noted that differing fees and rebates across market venues “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.” 

Steven Quirk, Senior Vice President of TD Ameritrade, disputed the conclusions reached in the Battalio paper.  Pressed, however, he did not dispute the paper’s finding that approximately 97% of TD Ameritrade’s retail limit orders were routed to market makers or the venue offering the most lucrative published liquidity rebates.  He testified that payments that his organization receives from selling its order flow “do not interfere with our efforts to seek quality execution and optimize the value proposition for our clients.”  He noted that clients receive disclosure about payment for order flow, and additionally, that the revenue “is used to operate our business and is indirectly passed back to clients” by lowering the cost of products and services offered.

Importantly, all of the witnesses affirmed that investors have benefited enormously from improvements in the US equity market structures made over the past few decades.  Regulatory initiatives have resulted in lowered transaction costs for all participants, and greater market competition. 

A video of the hearing, together with the written statements of all witnesses, can be found here: