The “Largest” Conflicts of Interest? Not so much…
Believe it or not, but IEX is, once again, using inflammatory rhetoric to advance its own agenda. This time, in a produced segment with MarketWatch, Brad Katsuyama claims that the “largest conflict in our market today, is that exchanges pay brokers [..] to send orders to them”. He then goes on to deride the volume statistics in the US markets as being irrelevant because they represent high turnover by high speed traders and concludes with his normal rhetoric against co-location and data.
I don’t want to reprise the reasons why IEX’s stance on co-location renders them less fair as I already have explained how they abdicate their responsibility to oversee connections to their exchange. I also don’t want to dignify his empty rhetoric claiming that US trading volume is irrelevant, but I will point out that every transaction cost model I know, and most (if not all) institutional traders, utilize average daily volume as a key data-point for predicting both how expensive orders will be to trade and determining the maximum size of an order to work in the market. What I do want to focus on, however, is his notion that rebates are the largest conflict in the market today…
First, as I have previously described as part of my “annotation” of Mr. Katsyama’s recent testimony, rebates are only a conflict if a firm working orders on behalf of clients fails to disclose or pass thru those rebates. Critically, readers should understand that rebates pose no conflict at all for market makers or professional traders who trade for their own account. Rebates are designed for that category of participant, and not the agency brokers that IEX focuses on. In that case, rebates are an incentive to provide liquidity and compensate firms for the risk of giving others an option to trade at the price of their posted orders.) This duality, where rebates are not a conflict for one type of participant at all, is important. It means that over-reaching regulation to restrict rebates risks harming the competitiveness of the US equity markets. (It is also worth pointing out that rebates are a fixture in many markets worldwide, which makes this risk more severe as a ban on US rebates could make overseas markets a more attractive alternative for global listings.) Thus, it is a far better idea to implement disclosure rules as a means of managing the conflict IEX cites. Of course, better disclosure rules would not help IEXs own profit interests as much as banning rebates. This is the irony in Mr. Katsuyama’s call for banning rebates to mitigate a conflict of interests; IEX would directly benefit from such a policy. If that were to happen, IEX would not have to compete with other exchanges that provide incentives for liquidity. If IEX were forced by competitive pressures to change their policy, however, it would reduce their profit margins. Thus, when IEX tries to influence the regulatory policy agenda or use “moral suasion” to persuade investors to not use rebate providing venues, all should be aware that, in this area, IEX has a major (and direct to-the-bottom-line) conflict of interest themselves.
The fact is, that financial markets have many examples of conflicts of interests, and all of them need to be managed. Examples range from stockbrokers being paid for more trading, investment banks making more money when the companies they research are valued higher, and agency brokers earning the same commission rate regardless of the costs they incur while trading. While some cases end up requiring regulation, the best first step is always to mandate enough disclosure to expose the behaviors that are troubling. This example is no different, which is why I have written two comment letters on the SEC’s order disclosure rule as well as numerous commentaries to clarify how such disclosures should be implemented.
NYSE Supporters Defend their Profit Margins…
Business Insider published an article citing several letters from industry sources objecting to Bats market on close proposal to match orders at a lower cost. These letters described in the article voice “confidence” in the current closing auction process and the Designated Market Makers (DMMs) that operate the auction. In addition, the article cites T Rowe Price and DMM firms as being concerned that this proposal could lead to fragmenting liquidity in the auction itself. The article lastly cites IEX as supporting the proposal, stating that it promotes competition.
My opinion, in this case, is to agree with IEX. The Bats proposal is not intended to fragment liquidity, but rather is designed to introduce price competition with the most expensive (and most profitable) transactions offered by the primary exchanges. As I have written previously, this is not a proposal for a competitive closing auction, but rather a way to, in aggregate, pre-match market on close orders. The orders being targeted in the proposal are where clients are price agnostic and willing to commit to the orders early, so they would have enough time to send their orders to the primary closing auction if they don’t match. Brokers already do this internally when they receive similar orders that pair off, so Bats is simply extending this process more broadly. Matched orders do not impact the price discovery process in an auction, but essentially “free ride” on the outcome. This is true whether they are matched at a broker, by a competing facility at lower cost, or as part of the auction product itself. The problem is that these “free riding” orders should be extremely inexpensive to match, but today incur the steepest net exchange fees of any orders, paying the same costs as orders which demand extensive interaction with the trading book, subsequent imbalance only orders, or, in the case of the NYSE, with the DMM’s judgement. While the “devil is in the details,” the concept of providing a low-cost alternative to orders that should be inexpensive to handle makes a lot of sense.
EU dictating US Market Structure?
Gary Stone from Bloomberg highlights the possibility that EU investors may be forced to ignore (or at least sidestep) some important trading venues when they buy or sell U.S. stocks. This is an important issue, as it would essentially mean that the EU regulators are forcing their investors to abdicate their best execution obligations in the US. (Since most institutional investors believe that, in some cases, dark trading is necessary to achieve best execution.) The issue is that US ATSs, for most stocks that also have listings in Europe, the trading in the dark exceeds the dark volume thresholds in MiFID II, which the article points out, could mean that all trading will need to be “on exchange”. Of course, even that is not likely good enough, since unlike their European counterparts, US exchanges have pure dark order types embedded in the exchange matching engines. One of our exchanges even trades the majority in the dark, so presumably, that could be “off limits” as well to European investors. While they are unlikely to, at this late date, change the dark trading rules in Europe, the EU regulators should try to extricate themselves from this predicament outside of their region. The simplest way is to not get too far into the details and grant “equivalence” to the US and other complex markets. If they can’t agree on that, we may get an object lesson in the institutional cost difference between transacting in US equities with the full range of options available, and what it costs when trading options are severely limited.