Regulators are looking into whether broker-dealers are being persuaded to place clients’ trades with exchanges or other centers based on factors that benefit the brokerage but are less than ideal for the investor.
Officials with the Financial Industry Regulatory Authority’s (Finra) market regulation department have launched a targeted exam, or sweep, into potential order routing conflicts of interest in the industry.
Specifically, they are asking an unknown number of broker-dealers to provide information regarding the impact receiving inducements has on those firms’ order-routing practices and decisions regarding both equities and options trades. These inducements include payments for order flow and maker-taker rebates. A payment for order flow is granted to brokerages for directing orders to specific exchanges or other market platforms for execution.
The concern is that broker-dealers may place trades at prices that are not the best available for the client because they will receive payment for doing so. ‘Recently there has been an increase in public discussion about the potential for conflicts of interest to affect order routing and execution quality,’ a Finra spokesperson notes. ‘Best execution of customer orders is a cornerstone of investor protection and for years has been a priority-focus area for Finra.’
The spokesperson notes that the self-regulatory organization in 2014 conducted a more general sweep regarding order routing and execution quality and issued related guidance in 2015.
‘We now want to take a deeper dive into the issue to ensure that firms are conducting regular and rigorous reviews, and managing conflicts appropriately,’ the spokesperson tells Corporate Secretary, explaining that firms targeted in the exam represent a cross-section of those that receive order-routing inducements. ‘We want to understand how firms are doing their execution-quality analysis and managing conflicts of interest,’ the spokesperson added.
In letters sent to the selected firms last month, Finra officials ask that they provide ‘complete and detailed responses’ to the following information requests:
- How does the firm quantify the benefits, if any, to its clients from the firm receiving order-routing inducements? Firms are asked to provide analytical or other evidence of such quantified benefits
- Describe how the firm fulfills its best execution duty and quantifies the benefits, if any, to its customers when routing orders of a particular type to a market center with transaction costs for that order type that are materially higher than the transaction costs for the same order type on other market centers
- Describe how the firm manages the conflict of interest that exists between its duty of best execution to customers and the firm’s own financial interests in situations where the firm routes customer orders to market centers that pay order-routing inducements or internalizes customer orders. The latter may involve routing customer orders to an affiliated over-the-counter market maker or alternative trading system, such as a dark pool, in which the brokerage has a financial interest.
Firms that receive the letters must respond this month.
Such sweeps can result in Finra introducing new guidance or a rule change, or even sometimes bringing enforcements. Whether the order-routing review leads to any such outcome ‘will be determined by the findings of the exam,’ the spokesperson says.
MAKER-TAKER ATTENTION
The maker-taker aspect of the US equity markets has drawn broader regulatory attention. SEC officials in an October 2015 memorandum describe how, to attract order flow while incentivizing market participants to provide liquidity at the most competitive prices, many exchanges and other non-exchange markets ‘have adopted a fee structure where they pay a per-share rebate to their members to encourage them to place resting liquidity-providing orders on their trading systems.’
If the trade is executed, the liquidity-providing ‘maker’ receives a rebate, and the ‘taker’ that executes against that resting order pays a fee to the market. This fee model has been the subject of significant attention and debate, with a particular focus on the effects it may have on market structure, broker routing practices and investor interests, the officials note.
SEC chair Jay Clayton in July said he expected the commission would in the coming months consider launching a pilot program to test how adjustments to the access fee cap would affect equities trading.
‘Such a pilot should provide the commission with more data to assess the effects of access fees and rebates — including maker-taker and other pricing systems — on liquidity provision, liquidity taking and order routing,’ he said. ‘These, in turn, affect the functioning of markets and investor welfare.’
Ben Maiden
Ben Maiden is the editor-at-large of Governance Intelligence, an IR Media publication, having joined the company in December 2016. He is based in New York. Ben was previously managing editor of Compliance Reporter, covering regulatory and compliance...
