US brokers should fear Massachusetts AG’s probe
Lucrative order routing revenues rely too much on clueless customers, says John Dizard
2 HOURS AGO by John Dizard
For all their complaints about the Trump administration, Wall Streeters have done quite well in getting a deregulatory agenda pushed through executive actions and appointments. With the (temporary) exception of the Consumer Financial Protection Bureau, the Treasury, Fed and other supervisory agencies are imposing fewer new rules and being more generous in their interpretation of old ones.
So those brave few Trump contributors and advisers on Wall Street have saved the day for the team, right? Not quite. They call it the United States and, if anything, the states part of the American regulatory environment is getting more aggressive. Each state has an attorney-general, and almost every one of those sees a governor in the mirror in the morning. The chief executive of a brokerage house might be on good terms with Treasury secretary Steven Mnuchin, but does he know the name of the attorney-general of Massachusetts?
Probably not, but Maura Healey, or, rather, someone in her office, knows his name. A few days ago, I sent a note to the securities division of the Massachusetts attorney-general asking for an opinion about an arcane American brokerage industry practice called payment for order flow, or order routing revenue. In reply, I was told that, “as the securities division has an open investigation on this very topic, we are not able to comment on this issue at this time”.
That is not a feel-good message for Wall Street. Payment for order flow is a significant revenue item for most, though not all, of the big brokers. In the second quarter of this year, TD Ameritrade received $83m in order routing revenues, out of total transaction revenues of $335m. In the same quarter, Charles Schwab brought in $26m of order routing fees out of total commission revenues of $142m. After a few years, that begins to add up to serious money.
And the margins are good, much better than on boring old commissions. Virtually all payment for order flow drops straight to the bottom line, since there is no need for advertising, help lines or legal support.
So that brings us to the question of what the brokerage house does to bring in those order flow payments or revenues. The money comes in little bips on every order that goes through exchanges and companies such as Citadel Execution Services, KCG, UBS Securities or Two Sigma, which execute the buy or sell orders directed to them from retail and institutional brokers.
But why would UBS Securities want to pay for the privilege of executing the 100 or 250 share buy or sell orders your mother places with Schwab? She is a nobody on Wall Street who does not know or care whether her order is executed a 10th or a 100th of a second later than someone else’s.
Exactly. That is the sort of customer you want in carload lots: clueless. If you are running a trading venue such as UBS, you want to be able to fill the requirements of sophisticated market participants who demand the best prices at any moment by slotting in buy or sell orders placed by millions of chumps. Otherwise we could not pay for all those tall buildings in financial districts.
Arguably brokers have a fiduciary responsibility to direct customers’ orders to the trading venue that offered the best price at the moment they are entered, not the one that offers the biggest kickback in the form of order flow payments. And while the order flow “arrangements” are disclosed in macro terms in the brokers’ “606” reports to the SEC, those reports are not really fulsome or specific to the customer.
There were hearings in the Senate on payment for order flow in 2014, led by the now-retired Senator Carl Levin.
Here are some of the quotes from the session with Steven Quirk, a TD Ameritrade executive:
Levin: And so, again, your subjective judgment as to which market provided best execution for tens of millions of customer orders virtually always led you to route orders to the markets that paid you the most.
Quirk: No, it would not have always led us.
Levin: I said virtually always.
Quirk: Virtually, yes.
Somehow, though, no change in federal policy came as a result of the Senate hearings. And since class-action suits against securities companies are not allowed under US law, the trial lawyers have lost interest.
The brokerages also seemed to believe that federal jurisdiction over securities law would pre-empt any state government action. But on a separate track in the courts, federal pre-emption was being limited. A 2009 Supreme Court case involving prescription drug labels, Wyeth v Levine, greenlighted state laws that are stricter than federal laws.
That opening for the state governments has now led to the Massachusetts attorney-general’s investigation.
I asked TD Ameritrade for its comment on the debate. A spokesperson replied that, “Federal law permits broker-dealers to route their orders to market centres in exchange for compensation, and the practice is recognised as a way to promote liquidity, price competition and competition among market centers.”
Perhaps that is no longer a good enough answer.
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