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.
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