By Lev Bagramian
In March of this year, the Securities and Exchange Commission, in a significant move, proposed a pilot to study “Transaction Fees” that equity exchanges impose on all those who trade on those exchanges. In a comment letter, we argued that fundamental market structure problems, particularly deeply rooted conflicts of interest, will not be solved by those who benefit from the system. Payments by the exchanges that incentivize and induce routing decisions by broker-dealers at the expense of best execution and market quality is one of those most entrenched and insidious market practices today, and it requires forceful and independent intervention by the SEC. A statutorily created, independent regulator – such as the SEC – with a mandate to protect investors, instill and maintain fair and orderly markets, and promote capital formation is the only entity that can and must solve these problems.
In the past few years, many in academia, in industry, on committees that advise regulators, and in Congress have identified and sounded the alarm about these kickbacks and other economic inducements that affect order routing decisions of broker-dealers. Specifically, they have highlighted how those decisions degrade best execution, contribute to the “darkening” of the markets, and increase market fragmentation and complexity. The preeminent concern related to kickbacks has centered on the potential for conflicts of interest between broker-dealers and their customers.
Today, broker-dealers knowingly route investors’ orders to exchanges that offer the highest kickbacks, in the process causing traffic jams (which reduces the probability of execution) or queues at these popular venues. The backups are serious enough to have a meaningful impact on the prices of the stock at which the investors’ orders are executed. So, even if at the time of routing, the exchanges are quoting the most favorable prices for a particular stock, thus creating sufficient grounds for a broker-dealer to claim s/he is in the best execution zone, the wait times due to the queues cause orders to either not execute or take longer to execute, resulting in a less favorable price. In the end, the broker-dealer benefits by collecting the rebate, while the investor is left with trades that were executed at less-than favorable prices.
The Commission, given its mandate to protect investors and promote fair and orderly markets, wants to get to the bottom of this issue through the above mentioned pilot, and we applaud them for recognizing their indispensable role in addressing this issue. Many, including institutional investors and pension funds that collectively manage over $8 trillion dollars on behalf of millions of savers and workers, have written to the SEC in support of the pilot. Unfortunately, but not surprisingly, exchanges that benefit from this broken and corrupt system of kickbacks are doing all they can to stifle and kill SEC’s efforts to solve, or at the minimum, to better understand the problem.
The New York Stock Exchange, and its many subsidiaries, are goading the companies listed on their exchanges to write to the SEC and request that they be allowed to opt-out of the study. The companies fear because of the pilot, the spreads (the difference between bid and ask prices of their stocks) will widen, in turn causing liquidity problems. Well-informed (and not-conflicted) experts have debunked these myths: see here, here and here. Our view is that the Commission should flatly reject any calls to permit issuers to opt-out of the pilot. Issuers currently have no say over exchanges’ policies that have distorted the markets and permitted these conflicts of interest to arise in the first place. Furthermore, exchanges that modify their access fees dozens of times a year do not survey issuers or permit them to opt-out of these fee changes or creation of order types. Finally, there simply is no evidence that the pilot will cause any imminent danger to any issuer’s stock price or liquidity. The pilot’s goal is to study the impact of certain practices followed by broker-dealers and exchanges. If issuers are permitted to opt-out, this will damage the integrity of the dataset and introduce weaknesses and doubts in the eventual conclusions, causing regulatory blindness and paralysis.
The Commission should move forward expeditiously to finalize and commence the pilot. Millions of investors are harmed by current market practices. While the harm to an individual investor may be small, taken collectively, these practices represent an enormous tax on investors as a class. Worse, investors receive no benefit in return. Far from it: They bear this tax and receive less than “best execution” of their trades. The Commission will need to be maximally informed and authoritative – and the pilot will help the Commission to be just that – to finally and comprehensively fix this aspect of our markets that continues to harm investors. We will remain vigilant in our advocacy to ensure the Commission fulfills its mandate of investor protection and promotion of fair and orderly markets.
 “Many investors do not access markets directly; instead, they rely on a broker to route their orders to one of many exchanges. Because they pay a commission, investors may believe that their broker will represent their best interests. However, most exchanges incentivize brokers to route orders for private gain, by using fee structures such as rebates for brokers who trade at their exchange.” See David Cimon, Broker Routing Decisions in Limit Order Markets 2 (Bank of Canada, Working Paper, 2017), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_ id=2789804.