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<div class="timestamp">May 6, 2012</div>
<h1>Study Says Broker Rebates Cost Investors Billions</h1>
<span><h6 class="byline">By NATHANIEL POPPER</h6></span>
<div id="articleBody">
<p>
The rules governing Wall Street generally force stockbrokers to seek out
the best prices for clients who pay them to buy and sell shares.
</p>
<p>
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. </p>
<p>
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 <a href="http://topics.nytimes.com/your-money/investments/mutual-funds-and-etfs/index.html?inline=nyt-classifier" title="More articles about mutual funds and exchange-traded funds." class="meta-classifier">mutual funds</a>, pension funds and ordinary investors as much as $5 billion a year. </p>
<p>
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. </p>
<p>
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. </p>
<p>
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. </p>
<p>
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. </p>
<p>
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. </p>
<p>
The losses to investors are usually gains for those high-speed trading firms and banks that factor the rebates into their <a href="http://topics.nytimes.com/top/reference/timestopics/subjects/h/high_frequency_algorithmic_trading/index.html?inline=nyt-classifier" title="More articles about high-frequency algorithmic trading." class="meta-classifier">automated trading</a> strategies, and who seek out the trades of less speedy and informed traders. </p>
<p>
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. </p>
<p>
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.” </p>
<p>
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. </p>
<p>
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. </p>
<p>
“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. </p>
<p>
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. </p>
<p>
“There are little pennies here and there all along the line. They do add up,” Mr. Conlin said. </p>
<p>
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. </p>
<p>
“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. </p>
<p>
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. </p>
<p>
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. </p>
<p>
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. </p>
<p>
The Big Board and Nasdaq initially resisted this model, but as they lost
market share to competitors, they eventually adopted it. </p>
<p>
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.
</p>
<p>
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. </p>
<p>
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. </p>
<p>
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. </p>
<p>
“In an ideal world, a router would simply look for the best execution,” Mr. Christiansen said. </p>
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<br>-- <br>Art Deco (Wayne A. Fox)<br><a href="mailto:art.deco.studios@gmail.com" target="_blank">art.deco.studios@gmail.com</a><br>