Michael Goldstein, Chair of Finance Department, Babson College
"Market regulations were not written for trading at the speed of light."
Washington - The Permanent Subcommittee on Investigations yesterday questioned industry figures about best execution in today's environment of rebate structures and payments for order flow. Chaired by Senator Carl Levin, the hearing took aim at the maker-taker model and its impact on investor confidence in US stock markets.
Initial testimony was provided by Robert Battalio, professor of finance at Mendoza College of Business at the University of Notre Dame. His team's research into rebate structures suggests that incentives created by maker-taker fees affects the way orders are routed.
"The conflict of interest associated with make take fee schedules arises from the fact that most brokers don't pass fees and rebates through directly to their customers but instead charge fixed commission rates that reflect fees, rebates and other costs of doing business," he said.
Battalio's testimony was supported by Brad Katsuyama, president and CEO of IEX, prominently featured in Michael Lewis' book Flash Boys.
"Due to the complex fee and rebate structure of trading venues, brokers have perverse incentives when deciding where and how to route customer trades," he said. "Many high quality studies, including the one from Professor Battalio, have demonstrated the relationship between a broker attempting to harvest rebates and worse execution quality for their customers.
"Based on our team's prior experience, we can confirm these findings."
Both Katsuyama and Battalio stopped short of recommending that the maker-taker model be abolished straight out, instead recommending standardised, mandated disclosures and at most, a pilot study to assess impacts on market structure. Canadian securities regulators are currently looking at running a pilot of this nature.
NYSE Group president Thomas Farley said that maker-taker pricing should be eliminated. "There are many examples of participants who are buying and selling at the exact same price, at the exact same time, on different venues in part to capture maker-taker rebates."
Farley also pointed out that in a period of rising stock prices, there has not been a corresponding rise in participation in the equities markets, which is at a 16-year low in percentage terms for US citizens.
BATS Global Markets CEO Joe Ratterman disagreed with a ban on maker-taker, pushing instead for greater transparency and disclosure in broker routing practices at both retail and institutional levels.
"Our exchange is in the business of matching buyers and sellers…when we have a trade we are going to deserve revenue for that trade," he said.
"As it happens, how we do that, there is today a significant amount of flexibility and I believe that flexibility has allowed for innovation in pricing (and) markets and that incrementally the rebates that are offered in many cases to market makers to take the risk to put bids and offers in the market has yielded tighter spreads over time."
However, he was not opposed to considering data coming out of any future pilot programme.
Also on the panel, Vanguard Group's principal and head of Global Equity Index, Joseph Brennan, said that the firm is in favour of looking at maker-taker as part of a comprehensive review of US regulations and market structure, as well as pilot testing any changes.
Steven Quirk, senior vice president of Trader Group at TD Ameritrade, defended the firm's routing practices, saying that interests of clients come first, and only after determining best execution are rebates and payment for order flow taken into consideration in making decisions. But he was pressed on the level to which TD Ameritrade ends up on the profitable side of the maker-taker model.
During the testimony, it emerged that in disclosures for the fourth quarter of 2012, TD Ameritrade directed all non-marketable customer orders to one venue, Direct Edge. Among all the exchanges, Direct Edge paid the highest rebate during that quarter. In the first quarter of 2014, TD Ameritrade routed all disclosed non-marketable orders to either Direct Edge or Lava Flow.
Quirk's estimate for how much was made in 2013 from fees based on payment for order flow is in the order of $80 million, while how much the firm paid out in taker fees "would not be significant".
Speaking to Automated Trader, co-founder of Themis Trading Sal Arnuk said that TD Ameritrade is hardly the only broker with this practice. "There are some very real conflicts of interest in the market place, specifically regarding broker routing, and while this senate hearing dealt with the world of retail the conflict of interest in institutional routing is far greater."
He added that there are other business models in the same space that do not thrive on the maker-taker model or have that conflict of interest. "To say that the business model can only work with payment for order flow is faulty."
Some commentators have been taking aiming at the way maker and taker designations are assigned by exchanges. Sal Arnuk added his voice to those observations. "There is an art form in the plumbing in being the maker as opposed to being the taker, without a doubt…There is an entire industry intent on gaming and making sure that (they are) getting the rebates."
Senate scrutiny comes at a time when a number of class action and other law suits are being brought against exchanges in the US, claiming unfair advantages being granted to high speed traders.
Michael Goldstein, chair of the Finance Department at Babson College, said that it is unclear what impact these lawsuits will have but he does expect it to bring about action - whether through changes in regulations or business practices.
Market regulations were not written for trading at the speed of light and in some sense, these lawsuits are coming down to: what are the fair rules of the game?
"A lot of our regulations (pre-date) the idea that the exchanges (are) publicly traded entities that have shareholders. It should be their right to profit maximise but they also have a public trust aspect to them," he said.
HFT, he added, seems to be at a stage where people are becoming more aware of industry practices.
"High frequency traders are not charities. Do we as society feel that the way they are making money has enough net benefit that we want to continue to support (HFT) through regulation or not?" he said. "Law suits are a way that America ex-post settles up."
The hearing also looked into establishing primacy of displayed quotes on regulated markets, high speed data feeds and colocation, among other issues.