A Matter of Trust

On June 17, Finance Professor Robert Battalio took a seat before a microphone in a stately, marble-paneled Senate hearing room across from Sens. Carl Levin and John McCain, the ranking members of the Homeland Security and Governmental Committee's Permanent Subcommittee on Investigations.

The subcommittee had called Battalio to testify at a hearing on potential conflicts of interest between low-cost stock brokerages and the ordinary investors who use them. Using proprietary market data, Battalio and his two co-authors—Shane Corwin, finance professor at the Mendoza College of Business, and Robert Jennings of Indiana University—had recently circulated a widely read research paper arguing that there is indeed such a conflict, and suggesting ways to resolve it.

The idea for the research project came in 2010, when the authors read a news article that quoted Christopher Nagy, then the head of order routing at the low-cost broker TD Ameritrade, explaining how the company executed its customers' orders. According to Nagy, Ameritrade routed its market orders—orders to buy or sell a stock at the best prevailing price—to market makers who were willing to pay Ameritrade for the honor of executing the orders.

However, the broker routed limit orders—orders to buy or sell a stock only at a predetermined price—to the exchange that offered the largest rebates for limit orders. There are now about a dozen public exchanges, including the New York Stock Exchange and Nasdaq, but also lesser-known ones with names like BATS and DirectEdge. These exchanges all compete for the brokerages' business, using these rebates as a major incentive.

In other words, Ameritrade was executing its customers' trades on the venue that paid it the most money. That was clearly good for Ameritrade, which was pocketing millions of dollars' worth of liquidity rebates each year. The question was whether it was good for Ameritrade's customers.

"We weren't aware that anyone was really doing this, so when we came across [Nagy's quote], we found it very interesting," Corwin said. "The hard part about this, as with so many of the topics we work on in market microstructure, is having the appropriate data to analyze the questions."

For the next two years, the researchers went from brokerage to brokerage asking to view their order routing data. No one was willing to hand it over. Finally, a major investment bank that also served as a broker-dealer stepped forward, offering to give them information about all the orders it executed in October and November of 2012—more than 28 million orders—as long as the researchers promised not to name the bank publicly.

Why would the bank do such a thing? Corwin speculates that the bank was questioning how its orders were being routed to the various trading venues and the impact of those routing decisions. It was likely hoping that the scholars could use the data to figure it out. "They were nice enough to give us the data, so we were happy to analyze it," he said.

When the researchers began sifting through public disclosures from other brokers, they quickly discovered that Ameritrade wasn't the only discount broker routing its trades to the highest bidder—E-Trade, Fidelity and Scottrade were all doing the same thing. More importantly, from the order data they learned that there was an inverse relationship between the exchanges' rebates and the execution quality provided to orders; the exchanges that paid the most to brokers also offered the lowest likelihood of limit order execution (or fill rate) to the brokers' customers. In other words, there was a conflict of interest between the stockbrokers and the customers whose interest they were supposed to be looking out for.

"We weren't aware that anyone was really doing this, so when we came across [Nagy's quote],
we found it very interesting," Corwin said.

To understand why high-rebate exchanges may be bad for investors, you have to understand that every stock exchange both pays rebates to brokers and charges fees, depending on the type of trade. The authors discovered that during those two months in 2012, Nasdaq BX, to take one example, was paying brokerages up to 14 cents (per hundred shares) for executing market orders, while charging up to 18 cents to execute limit orders. EDGX was doing just the opposite, paying brokerages up to 32 cents to execute their limit orders and charging 30 cents to execute their market orders.

If a low-cost broker such as Ameritrade routes all its orders to the highest-paying venue—sending all its limit orders to EDGX and all its market orders to either wholesalers or BX—that means its limit orders may not get executed. Imagine that Microsoft shares are trading at $55. You place a limit order to buy 100 shares if the stock falls to $50, and your brokerage routes that order to EDGX, because they pay the most for limit orders.

In a couple of hours, the price dips to $50 and I tell my own broker (who might be the same as yours) to place a market order to immediately sell my 100 shares of Microsoft. But instead of routing the order to EDGX, where I could sell my shares to you, my brokerage directs it to BX (in order to minimize fees), where it finds a different buyer, leaving you high and dry because after I sell my shares, the stock ticks up to $51 and your order goes unexecuted.

True, the brokerage only gets paid for executed trades, but the firm is betting on the fact that if you can't get the shares you at the higher price. Providing that the second order gets filled, the brokerage still pockets its same commission, but you lose $100 worth of potential profit.

Does the order routing decision matter in the real world? For actively traded, low-priced stocks including Sirius XM Radio and Microsoft, routing orders to the low-fee venue can improve the probability that limit orders execute by up to 25 percent. For higher priced stocks, such as Google, the routing decision is less important.

While the payments seem miniscule, these rebates are a major source of revenue for both brokerages and exchanges—given enough trades, 30 cents per 100 shares can quickly add up. Indeed, prior to the June 17 subcommittee hearing, Ameritrade revealed that it earned revenues of $236 million from order routing in 2013.

But for the average investor, isn't 30 cents a small price to pay for the $9.99 trading fees that Ameritrade and other low-cost brokers offer? In response to this, Professor Battalio says, "The point is, what's small? It's a matter of trust—you're supposed to be able to trust your broker, and if they're going to do things to their advantage when they know you're not looking, is that OK?"

"The point is, what's small? It's a matter of trust—you're supposed to be able to trust your broker, and if they're going to do things to their advantage when they know you're not looking, is that OK?" -Robert Battalio

Despite the conflict of interest he and his colleagues have identified, Battalio doesn't believe the market is rigged, as Michael Lewis argued in his recent bestselling book Flash Boys. The problem can be solved by requiring brokerages to pass along their rebates to their customers, which would make sure everyone's interests are aligned, or by simply requiring brokerages to make their order-routing data public. If investors knew more about how different brokers route trades, they could make a more informed decision about which broker to choose.

Toward the end of his Senate testimony, Battalio was asked by Senator McCain whether this conflict of interest between brokers and investors was really "a serious issue."

"We think it is," Battalio said, lowering his head to speak directly into the microphone. "But we also think it's an easy one to fix."

U.S. Senate Permanent Subcommittee Testimony

On June 17, Finance Professor Robert Battalio testified before the U.S. Senate Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs on "Conflicts of Interest in the U.S. Equity Markets."

Battalio's testimony addressed three areas of interest:

1. The conflicts of interest faced by retail brokers in
   determining how to route customer orders, as identified in his paper (co-authored with Shane Corwin and Robert Jennings) titled, "Can Brokers have it All? On the Relation between Make-Take Fees and Limit Order Execution Quality"
2. Other market conditions that may create conflicts of interest affecting brokers deciding where to route institutional and retail customer orders; and
3. Any recommendations for policies that could reduce or eliminate those conflicts of interest and enhance public confidence in U.S. equity markets

Read or watch Battalio's full testimony on the Senate subcommittee website at http://www.hsgac.senate.gov/ or by clicking this link: http://1.usa.gov/1kLaD5p

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Editor's Note: Battalio and Corwin's research has been widely cited in regulatory and legislative forums as well as by the media, including The Wall Street Journal, Bloomberg, Reuters and Traders Magazine. Most notably, subsequent to Battalio's Senate testimony, Carl Levin released a letter to SEC Chairwoman Mary Jo White calling for the elimination of the "maker-taker" system where exchanges pay market participants for some kinds of orders and charge fees for others. Referencing the Battalio-Corwin study, Levin called the practices conflicts of interest that "erode public confidence."

The research also became a focal point of a recent TD Ameritrade update meeting with Wall Street analysts, when one of the analysts pointedly asked CEO Fred Tomczyk to address the issues highlighted in the paper. RIABiz.com, a resource site for financial advisors, subsequently published a lengthy article presenting Tomczyk's comments and Battalio's responses.

Also, the Financial Industry Regulatory Authority sent "sweep letters" to 10 retail brokers in July, asking for details about how they route customer orders. According to The Wall Street Journal, Tom Gira, executive vice president of FINRA's market regulation department, said the regulator's concerns about brokerage routing practices were sparked by Corwin and Battalio's research.

Battalio and Corwin were awarded a prestigious Q-Group Research Grant in November 2013 for their study. Q-Group awards are given annually to a select group of researchers for superior academic research projects with potential applications in the field of investment management.