By John McCrank
April 2 U.S. market makers are increasingly paying discount brokers for trading business, raising questions about whether mom-and-pop investors get the best possible prices when they trade online.
Discount brokers send retail orders to market makers, which match buy and sell orders, and promise to try to get a better price than the one publicly posted by equities exchanges, in return for a fee.
In interviews, more than a dozen current and former executives from the brokerage, market-making and exchange industries said escalating fees create a conflict of interest for brokers, who have an incentive to fatten their own bottom lines rather than get the best deal for their customers. It means they might send orders to market makers even if they could have gotten a better trade price elsewhere.
The growth of the practice may be yet another sign that retail investors face disadvantages in U.S. equity markets compared to institutional players, despite vast improvements in transparency, speed and prices over the past decade.
"Payment for order flow is on an uphill climb, and in these markets, there has to be questions about how those conflicts are being reined in," said Chris Nagy, president of consulting firm KOR Trading LLC and former head of TD Ameritrade Holding Corp's order routing operations. "It's an area that needs more scrutiny."
The practice is banned in Canada, while Australia has proposed doing the same, and tighter controls have been introduced in the UK. But it remains legal in the United States, where it was pioneered in the 1980s by Bernie Madoff. (Madoff was convicted in 2009 for a massive fraud unrelated to the practice.)
Industry executives said U.S. regulators have been paying it scant attention even as the amount changing hands is increasing.
The Securities Exchange Commission, which requires firms to submit quarterly reports detailing their payment for order flow agreements and monthly reports on best execution, declined to comment. Two people familiar with the regulator's thinking said that it is cognizant of the "inherent conflict" in payment for order flow, but has no near-term plan to increase its scrutiny of the practice.
The brokers are particularly keen to boost the fees they receive for order flow and market makers are willing to pay more because they both need to offset revenue declines amid lower trading volumes in the aftermath of the financial crisis.
In a sign of how important the practice has become, market makers are falling over one another to get a piece of a Charles Schwab Corp contract that comes up for grabs next year, industry executives said.
If retail investors are suffering from the practice they probably wouldn't notice it because the amounts concerned would be small on a per-trade basis. But the fee payments can add up to hundreds of millions of dollars.
A Reuters review of the five largest U.S. discount brokers - TD Ameritrade, E*Trade Financial Corp, Fidelity Investments, Scottrade Inc and Schwab - found payments from market makers of as much as 32 cents per 100 shares in the fourth quarter.
An SEC study estimated eight brokers received only as much as 10 cents per 100 shares in the second quarter of 2009. While the SEC did not name the brokers, it did say that the survey included those with substantial retail customer accounts, which would include the big five discount brokers.
All the major market makers, including units of Knight Capital Group, E*Trade, Citadel LLC, Citigroup Inc and UBS AG, pay fees, according to regulatory filings.
Full-service brokers, such as Bank of America Corp's Merrill Lynch and Wells Fargo & Co, do not accept such payments, but charge significantly higher trading commissions.
Many large institutional investors do not allow their managers to engage in payment for order flow arrangements or other such incentives, demanding only best execution of their trades, said Andrew Lo, the director of the Laboratory for Financial Engineering at the MIT Sloan School of Management.
Executives from market makers argue they need to pay the fees to get the order flow and remain competitive. They say that the payments squeeze their profit margins and it doesn't mean they provide worse pricing.
Brokers say the payments do not impact how they route orders and the investors get the best possible deal. They also say the revenue allows them to pass on benefits to retail investors such as cheap trades, quick execution, free research and real-time market data.
TD Ameritrade constantly monitors market makers to ensure clients get the best deal, said Paul Jiganti, who heads the firm's routing strategy.
It is able to provide customers with free services partly by "using the money from payment for order flow," Jiganti added.
One market-making executive with direct knowledge of TD Ameritrade's order flow revenues estimated the broker brought in $200 million from the practice last year, or about 8 percent of its revenue and more than 20 percent of its pre-tax income in the fiscal year to last September. TD Ameritrade does not publicly disclose the figure.
Schwab, Scottrade and E*Trade declined to comment as did the market makers Citadel, UBS and Knight. Citigroup did not respond to requests for comment.
'MORE ART OVER SCIENCE'
Industry executives said brokers have leeway in determining what the best deal is for the client. Brokers are required to send retail orders to trading platforms that offer "best execution," which includes a number of factors, such as price and execution speed, creating a gray area around how exactly the best possible trade should be measured.
The Financial Industry Regulatory Authority does not normally second-guess order routing decisions, but it does examine individual trades to ensure they were completed efficiently and at the best price available, said Tom Gira, head of market regulation at FINRA, which has brought about 43 actions involving equities best execution violations since 2010, with fines totaling around $671,500.
Still, all other things being equal, FINRA has said brokerages can consider payment for order flow when making order routing decisions, Gira said.
"I think what that's led to is a lot...of ambiguity," he said. "It's kind of more art over science."
Brokers don't always get it right.
For example, E*Trade recently disclosed shortcomings in how it measured trade execution quality for orders sent to its market making unit, G1 Execution Services. E*Trade sends about 46 percent of its orders to G1, according to a filing. The company's methods were called into question by Kenneth Griffin, who until recently was an E*Trade director and who also runs Citadel, which competes with G1. E*Trade said it changed its practices to comply with regulations, and declined to comment further.
One firm that receives lower fees is Fidelity. That is partly because it has very high standards for the execution of trades, demanding more than its major rivals - particularly when it comes to improving on available prices, industry insiders said. Fidelity also allows institutional investors to trade against its retail flow before routing it to brokers, which makes the order flow less valuable to others.
A Fidelity spokesman said it always tries to get best execution for its clients but declined to comment further.
One of Fidelity's top destinations for order flow in the fourth quarter was Knight, which paid it 5 cents per 100 shares. In comparison, Knight paid TD Ameritrade less than 30 cents per 100 shares on average in the quarter, up from less than 20 cents six months earlier. Knight paid Scottrade 28 cents or less per 100 shares, up from 13 cents or less in the third quarter, regulatory filings showed.
Overall last year, Knight paid $90.6 million to firms for order flow, up 7 percent from 2011, and more than doubling from $37.7 million in 2010.
Other market makers as well as brokers do not disclose how much they pay overall for order flow, but available data all point to more money changing hands. The amount Schwab received, for example, rose by $23 million last year, according to a filing. It doesn't disclose the full amount.
"The complexity of these arrangements and the lack of transparency really give rise to opportunities for conflicts of interest that probably outweigh the economic benefits of payment for order flow," MIT's Lo said.
TALK TO CHUCK
Next year, a long-time deal between Schwab and UBS, which takes nearly all of Schwab clients' stock orders, expires. Schwab's 8.8 million brokerage clients averaged 282,700 revenue-generating stock trades a day last year. While that is less than the nearly 360,000 trades a day by TD Ameritrade's 5.6 million clients, Schwab's order flow is seen as more valuable.
The possibility of getting a piece of that contract was already creating buzz at an industry conference in Chicago in January, people who were at the event said.
The practice flourishes around retail order flow, known in the industry as "dumb money." Mom-and-pop investors are typically less aware of short-term price movements in a stock, making it easy for firms looking to capitalize on price changes from one moment to the next to profit from retail orders.
Schwab's client base is seen as less informed and less active than at other firms, said the market making executive, who attended the conference.
"With Schwab, it truly is mom and pop buying Wal-Mart or Cisco or Target," the executive said. Schwab declined to comment on how its clients are perceived.
Knight CEO Tom Joyce met with Schwab about a possible deal around four months ago, and lower-level meetings have been happening since, said a person with direct knowledge of the matter. Similar meetings have been happening between Schwab and the other major market markers, several sources said.
Schwab denied it has met with any market makers on potential order flow deals. UBS declined to comment.