The Great Debate Over Order Routing

Terry Flanagan

Discussions of whether or not customers of broker-dealers benefit from practices such as broker internalization and payment for order flow often ignore the fact that order routing decisions are based on a variety of factors, including commission rates.

“The elephant in the room is that routing decisions made by brokers were tiered,” said Alfred Eskandar, CEO of trading systems provider Portware. “Depending on your commission rate, depending on your level of relationship and your sophistication, your order was either routed to (the broker’s) benefit or it was routed to your benefit. That’s a practice that happened across the board.”

Eskandar added, “If you have pushed my commissions down by 60% or 70%, I’m going to look to cut my costs as much as possible because my revenue line is down. The way I cut my cost in executing equity orders is I’m going to route to the places, the venues–the 40 dark pools and 13 exchanges etc.– who are going to be cost-effective.”

With commission dollars shrinking, brokers must find new ways to demonstrate their value to buy-side clients, according to Greenwich Associates. The next generation of sales trader tools—many of which already exist and are available for the taking—go beyond the CRM systems common today and are improving rapidly. For example, only one-fifth of brokers use predictive analytics to help clients, a number Greenwich Associates expects to jump in the coming years.

In exchange for getting a cheaper commission rate, customers have had to sacrifice some spread-capture opportunities when their broker routes orders. “It’s only fair to say that clients, not all of them, but certain clients, were perfectly in-the-know and comfortable with that exchange,” said Eskandar. “Some clients have even justified it by saying that the lesser commission rate was actually of greater value than the potential for spread capture and I’m fulfilling my fiduciary obligation.”

Payment for order flow, by which trading venues offer rebates for sell-side firms in exchange for their retail orders, actually benefits retail customers, according to Eskandar. “The empirical data shows that the client is benefiting,” he said. “The retail investor gets more benefit, more tools and more attention paid to their order than the institutional guy.”

NYSE president Thomas Farley noted in Senate testimony in June that although long-term investors have benefited in many ways from the implementation of Reg NMS, data now shows that some of these benefits, such as lower costs, might be reversing.

Farley said that large institutional investors complain that there are too many conflicts in the current market structure and that they would like to see those conflicts eliminated or, at least, reduced.

“Many incentives are in place to keep orders away from the public markets where they would interact with displayed liquidity,” he stated. “These incentives often conflict with the interests of the investor whose orders are being executed off of public markets and are always inconsistent with the interests of those participants who are displaying trading interest.”

Featured image via madpixblue/Dollar Photo Club

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