[Vision2020] Study Says Broker Rebates Cost Investors Billions

Art Deco art.deco.studios at gmail.com
Mon May 7 12:40:14 PDT 2012


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May 6, 2012
Study Says Broker Rebates Cost Investors Billions By NATHANIEL POPPER

The rules governing Wall Street generally force stockbrokers to seek out
the best prices for clients who pay them to buy and sell shares.

In recent years, though, brokers have had another enticement that can pull
them in a different direction: payments from stock exchanges in return for
sending them business.

The practice has attracted criticism from several industry participants and
former regulators who say the so-called rebates that the exchanges pay Wall
Street firms could give those firms an incentive to profit at the expense
of investors. Now a new study using industry data says that the rebates
could be costing mutual
funds<http://topics.nytimes.com/your-money/investments/mutual-funds-and-etfs/index.html?inline=nyt-classifier>,
pension funds and ordinary investors as much as $5 billion a year.

The 75-page study, being released this week, was written by Woodbine
Associates, a financial consulting firm that does business with players on
all sides of the issue. Woodbine said the report was done independently,
without support from industry participants.

Some financial firms criticized Woodbine’s calculations and said the cost
to investors was overblown, but did not dispute that the potential for a
conflict of interest exists.

The study estimates that investors lost an average of four-tenths of a cent
on each of the 1.37 trillion shares traded last year because of orders
being sent to exchanges that were not offering the best final price. Stocks
are sent to exchanges with inferior prices for reasons other than rebates,
and the study’s tally includes those losses, but the authors say that the
primary reasons for bad routing decisions are the rebates.

In one hypothetical situation, a mutual fund might ask its broker to buy
one million shares of a major company. The broker sees that one exchange
has a seller willing to part with the shares for $100 while another
exchange has a seller offering $100.01 but is also offering the broker a
tenth of a cent rebate per share. The mutual fund could end up paying
$10,000 more than it needed to, while the broker would keep the $1,000
rebate.

The report puts a new spotlight on one of the most controversial practices
that has sprung up as a growing number of exchanges have battled for the
business of high-frequency traders and banks.

The losses to investors are usually gains for those high-speed trading
firms and banks that factor the rebates into their automated
trading<http://topics.nytimes.com/top/reference/timestopics/subjects/h/high_frequency_algorithmic_trading/index.html?inline=nyt-classifier>strategies,
and who seek out the trades of less speedy and informed
traders.

In March, another financial consulting firm, Pragma, issued a report that
drew attention to the conflict of interest created by rebates. Last fall,
Jeffrey Sprecher, the head of the IntercontinentalExchange for futures and
options, said at a conference that he would “have the regulators outlaw
maker-taker pricing,” another name for the rebate system.

The most prominent criticism came in a 2010 report by two former chief
economists at the Securities and Exchange Commission who said that “in
other contexts, these payments would be recognized as illegal kickbacks.”

One of those economists, Chester Spatt, said that his group’s report
initially generated conversation among regulators but was then overshadowed
by the so-called flash crash of May 2010, in which stocks experienced a
sudden and irrational plunge. The S.E.C. raised questions about the rebates
offered by exchanges in a policy paper in 2010 but has not acted on it
since.

Mr. Spatt said in an interview that the problem caused by rebates has not
gone away and has most likely intensified as other sources of revenue for
brokers have shrunk.

“Presumably many are acting in a self-interested fashion, and the
self-interest leads to a lot of distortion,” said Mr. Spatt, who is now a
professor at Carnegie Mellon. The report was sponsored by the trading firm
Knight Capital.

Even before being officially published, the figures from Woodbine sparked a
debate about the proper way to calculate whether clients were getting the
best price in a given trade. According to Bill Conlin, the chief executive
of the independent brokerage firm Abel Noser, the Woodbine report includes
only one of the many costs that determine whether a broker’s client makes
money, and that cost may not be the one that hurts investors most.

“There are little pennies here and there all along the line. They do add
up,” Mr. Conlin said.

On the other side of the debate, high-speed trading firms say that the
increased levels of trading promoted by the rebates lower overall
transaction costs for investors. And exchanges say the rebates are
necessary to attract people who will make markets with ordinary investors,
providing those investors with the ability to liquidate their holdings
whenever they want.

“We believe it’s important to incent market makers to provide liquidity so
that all traders can buy when they want to buy and sell when they want to
sell,” said Randy Williams, a spokesman at BATS Exchange, one of the
nation’s four large stock exchange companies.

The laws governing exchanges are meant to ensure that the rebates do not
result in customers getting a worse price for their stocks. If an exchange
has the best offer at a given moment, other exchanges have to send orders
there.

But in today’s high-speed fragmented markets, there are several instances
in which this rule does not protect investors. For instance, if a broker
sends the first 100 shares of an order to the exchange with the best price,
the broker can send the rest of the shares to another exchange where it
will receive a larger rebate. Several academic studies have found that the
cost of executing trades is at a record low. But Matt Samelson, the founder
of Woodbine, said these calculations have not factored in the “hidden
prices” that can be incurred when investors don’t get the best price.

When the New York Stock Exchange was the nation’s dominant one, it did not
need to pay traders to use its floor. Both buyers and sellers would pay the
exchange for the opportunity to execute a trade. In the 1990s, though, some
upstart platforms for trading, like Island Exchange, wanted to attract
buyers and sellers and began to offer payments for brokers who brought them
orders to post on the Island platform. When other traders wanted to take
the other side of those orders, they would pay Island, and Island would
make the difference between the rebate and the payment it received.

The Big Board and Nasdaq initially resisted this model, but as they lost
market share to competitors, they eventually adopted it.

Nasdaq paid out $306 million in rebates in the first quarter of this year,
or nearly half of its revenue. That was a greater proportion than that paid
by the New York Exchange. All 13 of the nation’s exchanges offer some sort
of rebate program. Brokers can pass rebates along to their clients, but
rarely do, according to industry participants.

The rules governing rebates are incredibly complex, ensuring that no one
exchange has a regular edge. But the brokers are constantly tweaking their
programs to ensure they are paying the lowest possible prices to execute
customer trades, and receiving the maximum rebates.

Woodbine’s method of determining the cost of this to investors involves
complex calculations of how frequently investors get the best price on each
exchange.

Tim Christiansen, who manages stocks at Sawgrass Asset Management, said
that the highly technical details involved in every trade made it hard to
draw industrywide conclusions on investors’ costs. But in his own work, he
has noticed that certain brokers have sent his orders to exchanges where he
did not get the best price.

“In an ideal world, a router would simply look for the best execution,” Mr.
Christiansen said.

-- 
Art Deco (Wayne A. Fox)
art.deco.studios at gmail.com
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