Better Markets filed a supplemental comment letter with the Securities and Exchange Commission in response to the SEC’s proposal to prevent national securities exchanges from offering volume-based pricing in connection with certain transactions. The use of volume-based transaction pricing harms competition by preventing smaller exchanges from competing with larger exchanges and by preventing smaller brokers from competing with larger brokers. It also presents conflicts of interest for both brokers and exchanges. The SEC has the authority to adopt the proposal, and it should do so to foster competition and eliminate the conflicts of interest that volume-based pricing present.
Why It Matters. National securities exchanges, to induce brokers to trade on their exchanges, offer brokers lower fees or higher rebates as the number of shares the broker executes on the exchange reaches successively higher levels. This entices brokers who have a high volume of trading to route all orders to the same exchange. So exchanges that do not already have a significant percentage of a broker’s order flow may not be able to compete for the broker’s remaining order flow as they will not be able to offer competitive pricing. Brokers with a lower volume of trading may also not be able to compete with higher volume brokers because they will not be able to offer their customers competitive pricing either. Unlike higher volume brokers who receive lower fees or higher rebates, lower volume brokers will not be able to pass on any cost savings from lower fees or higher rebates.
The incentive to route orders to a particular exchange in order to qualify for that exchange’s advantageous volume-based pricing also presents brokers with a conflict of interest. The economic incentive to route customer orders to a particular exchange to receive favorable volume-based pricing on that specific exchange forces brokers to choose between achieving the best prices for themselves and achieving the best execution for their customers. Brokers may be induced to route order flow to an exchange not because it offers the best execution quality for their customers but because it benefits the broker to route the order to the exchange that offers the broker more favorable pricing than other exchanges.
Volume-based pricing also presents a conflict of interest for the exchanges. National securities exchanges are self-regulatory organizations, which means that they are responsible for enacting rules to govern trading on the exchange, monitoring the activity of their members for compliance with those rules, and disciplining members who fail to comply. But exchanges who try to attract high-volume brokers through lower fees or higher rebates may be reluctant to punish such brokers when they fail to follow the rules.
What We Said. We support the SEC’s proposal to curtail the use of volume-based pricing by national securities exchanges. There should be no question that the SEC has the authority to adopt the proposal. The SEC has the authority to promulgate rules to discharge its responsibility to oversee the national securities exchanges, and part of that responsibility entails ensuring that the exchanges provide for the equitable allocation of dues, fees, and other charges among its members; not permit unfair discrimination between brokers; and not impose an undue burden on competition. Indeed, one of the purposes of the securities laws is to ensure fair competition among brokers and exchanges. So the SEC has ample authority to prohibit national securities exchanges from offering volume-based pricing.
There should also be no question that volume-based pricing presents conflicts of interest that should be eliminated. Research shows that there is a negative relationship between order execution quality and the amount of money paid for order flow, which suggests that incentivizing brokers to send orders to certain exchanges in order to receive lower fees or higher rebates from those exchanges does not maximize order execution quality.
Exchanges also face deleterious conflicts of interest from volume-based pricing. Exchanges want to capture order flow, and if they do so by offering large brokers better pricing they will have no incentive to discipline those brokers for misconduct. Customers will ultimately be harmed if national securities exchanges do not fulfill their self-regulatory obligations.
Bottom Line. Better Markets supports the SEC’s efforts to ensure competition among exchanges and brokers, and eliminate or mitigate conflicts of interest, by preventing national securities exchanges from using volume-based pricing.
