Brokerage Prices Don’t Reflect Actual Trading Costs, Study Says
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By Whitney Kisling and Nina Mehta
Feb. 24 (Bloomberg) -- The U.S. Securities and Exchange Commission should require brokers to include transaction fees and rebates in customer prices to reflect actual trading costs, according to a study released yesterday.
In the pricing model used by all U.S. stock exchanges, traders who post orders are paid a rebate as an incentive to boost liquidity, while those who execute against them must pay a fee. Existing rules require brokers to transact sales at the best bid price or higher and buy orders at the best ask price or better, without accounting for fees or rebates.
Exchanges employ this pricing system, known as the make-or- take model, to win business from high-frequency traders, who account for the largest chunk of equity volume and use computer- driven strategies that can produce hundreds of buy and sell orders every second. This affects the decisions brokers make when routing orders to markets and has produced strategies designed to avoid fees, which affects the bid-ask spread on exchanges, the professors who conducted the study said.
“Make-or-take pricing has significantly distorted trading,” wrote James Angel of Georgetown University in Washington, Lawrence Harris of the University of Southern California in Los Angeles and Chester Spatt of Carnegie Mellon University in Pittsburgh. “Brokers make most order-routing decisions based on the quoted prices that their clients will receive, and not the true net prices of the trades.”
Knight Capital
Harris and Spatt are former chief economists at the SEC. Angel has chaired the Nasdaq Economic Advisory Board. The study, which examines the impact of technology on markets and brokers’ execution decisions, was commissioned by Knight Capital Group Inc. The Jersey City, New Jersey-based financial-services firm has commented on several market-structure rule proposals put forth by the SEC.
Spreads between bid and ask prices have narrowed as a rule introduced in 1997 required orders to be executed at the best prices no matter which venue posted them, and another in 2001 cut quoting increments to a penny. While the tighter spreads improve the prices for the client, they don’t reflect the total fees for the broker to execute a transaction, making it more difficult to determine “true costs,” according to the study.
The make-or-take pricing model “creates perverse incentives for some broker-dealers who may prioritize margin considerations over liquidity and best execution obligations,” said Joe Gawronski, president and chief operating officer at Rosenblatt Securities Inc. in New York.
Serving Clients
“The SEC could solve these make-or-take problems by requiring that all brokers pass through access fees and liquidity rebates to their clients,” the professors wrote. “These changes would ensure that brokers route all orders to best serve their clients, rather than enrich themselves.” The commission should also ensure that the best execution mandate for brokers applies “to net prices and not to quoted prices,” they said.
Another solution would be for the SEC to ban access fees, making quotes comparable across all exchanges, according to the professors.
The authors said exchanges shouldn’t be allowed to “require that traders pay them to trade with their clients” and that brokers shouldn’t be able to get rebates for routing clients’ limit orders to particular venues. “In other contexts, these payments would be recognized as illegal kickbacks,” they wrote, citing common law concerning agents.
Exchanges have been introducing platforms with different fees and prices to cater to clients as competition for equity market share increases. Bats Global Markets, owner of the fourth-largest U.S. stock venue, plans to open a second trading network this summer. Nasdaq OMX Group Inc., which owns the second-largest platform, announced in October that it would start a third with its Nasdaq OMX PHLX license, which it got when it bought the Philadelphia Stock Exchange in 2008. |
