Morgan Stanley is stepping up its campaign to reform industry order handling practices.
Earlier this month, in a meeting with the Securities and Exchange Commission, the big broker urged the regulator to consider new rules requiring brokers to provide detailed disclosure of their order routing practices to their institutional customers.
The petition was at least the second time in the past year that Morgan has pressed the SEC to address what it considers "aggressive" order-handling practices by brokers.
For the past three years, the big broker has been warning the buyside about the conflicts of interest and economic risks inherent in the routing decisions of institutional brokers and exchanges. Morgan’s focus is primarily on dark pools and how routing to them can enrich the broker or exchange and subject the buyside customer to unnecessary price risk.
In its quest to force changes on the way brokers and exchanges operate, Morgan has spoken out at industry conferences, courted the press, and consulted with its clients directly. In 2008 and 2010, it sent letters to its customers suggesting questions to ask their brokers regarding their order handling practices.
Morgan wants the SEC to consider mandating that brokers provide their customers with details of their order-routing decisions in quarterly reports. Any such report would include the identity of the venue in which an order was filled; the names of the venues the order passed through; and the level of the fill rates at each venue.
At the heart of Morgan’s concern is that some brokers and exchanges are taking improper liberties with their customers’ orders. Despite the fact that the preponderance of liquidity is located on the public exchanges, many brokers and exchanges are routing to the cheaper or free venues first in an attempt to keep their costs down, the broker maintains.
The firm’s concerns are shared by the buyside. The Investment Company Institute told the SEC in a letter last year that the regulator should "consider means to require new disclosure or to improve existing disclosure … regarding the order routing and execution practices of brokers and trading venues."
At least one broker regards SEC intervention as unnecessary. While he believes buyside clients are entitled to information about the handling of their orders, Dan Mathisson, head of Advanced Execution Services at Credit Suisse, does not see the need for regulation.
"That is something I would rather see enforced by the clients themselves," Mathisson said. "It’s very easy for a money manager to announce that any broker that doesn’t give them the information it believes it should have about its orders will not receive any orders. This is a problem the free market can solve."
Mathisson says Credit Suisse provides those customers who request it information about where their orders were executed and where they weren’t on a daily, weekly, monthly, or quarterly basis. "That is a fairly widespread practice," he added. "So do you need a regulation that tells people to do what they are already doing? It would be a shame to increase everybody’s costs and overhead by adding to the compliance burden."
Morgan Stanley’s biggest problem is with the dark pools. In a paper it presented to the SEC, the firm stressed brokers route to dark pools to avoid exchange fees. It estimated that a relatively large brokerage, trading 100 million shares per day on average, could save $70 million per year routing to a dark pool rather than to an exchange.
Such routing practices are at odds with a broker’s duty of best execution, Morgan contends. Because some dark pools probe other pools or allow probing by traders, their usage can result in information leakage. That could cause price moves that hurt the buyside trader.
The firm believes that buyside traders should be given a choice as to whether they want their orders to participate in a routing strategy "outside of a direct route to an exchange," it wrote in the paper.
Morgan also suggests that the SEC reduce the mandated cap on exchange fees from 30 mils to five mils or 10 mils. By making it cheaper to take liquidity on the exchanges, brokers will have less incentive to avoid them, it argues.
Morgan isn’t confining its criticism to institutional brokerages. It also told the SEC the regulator should take a look at the routing practices of exchanges as well. In recent years, some exchanges have adopted policies to route their unfilled orders to dark pools rather than other exchanges. That lets them avoid paying another exchange’s take charge. It also serves to deny the competitor exchange an opportunity to boost its market share. Nasdaq, NYSE Arca and Direct Edge have all adopted such programs.
Morgan believes this practice should be banned. And if the SEC chooses not to ban it, then, at a minimum, the exchanges’ brokerage units, which facilitate the routing, should be regulated as any "regular" broker. The units should be subject to best execution and other obligations. Currently, the exchanges’ broker-dealer subsidiaries are treated differently than traditional brokerages by the regulators.
Morgan Stanley would not comment for this article, but this is not its first attempt to put the order routing issue in front of the SEC. Last year, in a letter to the regulator addressing potential regulation of dark pools, Morgan told the SEC the underlying problem was "the conduct of market participants." The broker suggested the SEC needed to focus on "meaningful transparency and renewed emphasis on up-to-date order handling/routing practices."
The SEC does have rules on its books requiring disclosure of order handling practices. Rule 606, in particular, requires brokers to divulge where they filled their customers’ orders. It covers orders of less than 10,000 shares, however, and is generally considered applicable to retail orders.
Goldman Sachs, which has undertaken a campaign of its own to bring transparency to brokers’ order-handling practices, has suggested the Commission consider beefing up its Rule 606. In a letter it sent to the SEC last June, Goldman asked the regulator to consider expanding Rule 606 to cover orders that do not receive executions.
Greg Tusar, co-head of electronic trading at Goldman, told Traders Magazine last fall that Rule 606 was out of date. Rule 606 "tells you at the end of the day where [an order] was executed, but it doesn’t tell you the manner in which your order was handled, and how you searched for liquidity. For example, did you ping in six different places before you actually went and removed the offer? Those are the things that clients want to understand better," Tusar said.
Morgan Stanley’s campaign to reform order handling practices is not completely altruistic. Sources close to the broker say the endgame is to level the playing field so that Morgan Stanley and its own dark pool pick up market share. By shedding light on competitors’ aggressive order handling practices, any regulation will force them to change their ways, bringing them to Morgan Stanley’s level.
One indication of a broker’s success is the size of its dark pool. Under that measure, Morgan Stanley is somewhat of a laggard. The firm operates a dark pool called MS-Pool. On average, it traded about 60 million shares per day in a the month ended Jan. 11, according to Rosenblatt Securities, which tracks dark pool volume. That makes it the seventh largest dark pool tracked by Rosenblatt and considerably smaller than the pools operated by rivals Credit Suisse and Goldman Sachs.
The small size of MS-Pool is partly due to its rules, sources say. Morgan Stanley limits the types of traders it allows in and maintains strict rules of engagement. For example, the firm does not allow traders to "ping," or probe, MS-Pool with small, immediate-or-cancel orders. It does not send out indications of interest. And it requires a minimum resting time in the pool.
