(Bloomberg) — U.S. stock exchanges and brokers who use obscure incentives and fees to promote high-speed trading face questioning about those practices today as senators examine whether they pose a conflict of interest and harm investors.
Executives from Intercontinental Exchange Inc., owner of the New York Stock Exchange, Bats Global Markets Inc. and TD Ameritrade Holding Corp. are under scrutiny by the Senates Permanent Subcommittee on Investigations for rebate fees and payments for orders that have encouraged ever-faster trading since the late 1990s. High-frequency traders now account for about half of U.S. stock trades.
Senator Carl Levin, the Michigan Democrat who leads the panel, called the hearing to examine conflicts of interest in equity markets that threaten to damage investors and to erode the trust and confidence on which our free markets depend.
The committee, which is known for highly-publicized investigations of Wall Street following the 2008 credit crisis, scheduled the hearing amid increasing concern that stock markets and regulators ability to oversee them are in need of change. The 2010 flash crash, a series of technological failures and the book Flash Boys by bestselling author Michael Lewis have fed scrutiny of high-speed and off-exchange trading.
Investigations Opened
Eric Schneiderman, the New York attorney general, has subpoenaed high-speed traders including Chopper Trading LLC, Jump Trading LLC and Tower Research Capital LLC as part of a probe into automated trading, a person familiar with the matter said in April. The Securities and Exchange Commission and Commodity Futures Trading Commission are also investigating whether the traders benefit unfairly from better access to data or other incentives.
The SEC, which has been weighing changes to the structure of U.S. equity markets since 2009, is considering its most sweeping plan yet for reining in high-speed trading, Chair Mary Jo White said in a speech on June 5. The plan would increase registration of proprietary traders and disclosure by brokers and dark pools — broker-owned venues that compete with traditional exchanges but keep orders hidden until theyre completed.
Brad Katsuyama, president and chief executive of IEX Group Inc., will lead off the testimony. He was a central character in Lewiss book for his efforts to limit predatory trading strategies and increase market transparency.
Exchanges Testify
Katsuyama will be followed by Thomas Farley, president of NYSE Group, Joseph Ratterman, chief executive of BATS, Joseph Brennan, head of the global equity group at the Vanguard Group Inc., and Steven Quirk, senior vice president at TD Ameritrade. Robert Battalio, a professor at the University of Notre Dame who co-authored a study that concluded that brokerages put their own interests ahead of their clients, is also slated to appear.
Lawmakers and regulators have previously focused on whether high-frequency firms should register and if off-exchange trading platforms need better disclosure. By contrast, todays hearing will focus on the financial relationships between exchanges, brokers and traders.
When fees and payments are not passed through from brokers to customers, they can create conflicts of interest and raise serious questions about whether such conflicts can be effectively managed, White said on June 5.
Order Flow
Levin plans to highlight a system known as payment for order flow in which retail brokers such as TD Ameritrade and Charles Schwab Corp. are paid to send client orders to third- party specialists. Those firms, such as Citadel LLC and KCG Holdings Inc., which profit from taking the other side of the trades, are bound by rules meant to ensure they get the best price possible for investors.
In a statement, Levins committee said the payment system creates a conflict because the wholesale broker who offers to pay the most for the order flow may not get the best prices for customers when executing the trades. In his book, Lewis criticized the practice for being designed to maximize the number of times an ordinary trader would collide with a high- speed trader.
TD Ameritrade said in a June 12 statement that it received $236 million in revenue in 2013 for routing orders and said the practice was subject to regulation, oversight and proper disclosure and produces lower, not higher prices, for retail customers.
The facts show that execution quality for retail investors has never been better, Fred Tomczyk, the brokerages president and chief executive, said in the statement.
Maker-Taker
Levin also plans to scrutinize a separate system of incentives between exchanges and high-speed traders known in the industry as maker-taker. The system is the predominant way exchanges attract orders from brokers. Traders who are ready to buy or sell shares as needed, known as market makers, are paid rebates by an exchange. Traders on the other side, the takers, instead pay a fee.
Most stock exchanges charge about 30 cents per 100 shares to firms that trade against standing buy and sell requests. The exchanges pay less to brokers who supply them with liquidity, and profit off the difference between those fees.
Critics of maker-taker, including ICE Chief Executive Officer Jeffrey Sprecher, say it presents another conflict of interest for brokers who may shop for rebates instead of putting clients first. Other critics say it contributes to the race for speed because many high-frequency traders have employed strategies that involve capturing rebates.
Payments Integral
The rebate programs and payments for orders are two concepts that are integral to the way business is done today and have gotten the most scrutiny, Richard Repetto, exchange analyst at Sandler ONeill & Partners LP in New York, said in a telephone interview. But that doesnt mean you change them without thought and analysis.
White said on June 5 that she has asked the SECs staff to recommend a rule to improve disclosure of customer-specific information about how orders are routed. A rule is necessary to ensure that the disclosed information is useful, reliable, and uniformly available on request to all institutional customers, she said.
