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
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
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
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
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
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.