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Rhetoric of Massachusetts Inquiry Risks Dangerous Politicization of Rebates

Traders Magazine Online News, August 29, 2017

David Weisberger

The current U.S. equity market provides American companies a competitive advantage due to the liquidity that trades on our markets every day.  In fact, the average stock trades more than double the percentage of its market cap in America, than the other G7 markets.  This is a boon to American companies, translating directly into an advantage for raising money and acquisition strategies, which ultimately means both more jobs and retirement wealth for millions of Americans.

With that as a backdrop, the news that Massachusetts Secretary Galvin is basing an “inquiry” into firms routing practices based on a self-interested tissue of lies, is a scary proposition.  According to the WSJ and FT articles, the investigation is based on a NYT OpEd, which was essentially an infomercial for IEX, a corporation valued in the hundreds of millions of dollars by their investors, who wants rebates banned in order to limit their competition.  The editorial in question was written by Yale professors, whose Dean of Leadership (Jeffrey Sonnenfeld) has been a paid consultant (for cash and stock) for IEX and a current board member (with stock compensation), whose CEO conferences are sponsored by IEX for hundreds of thousands of dollars and whose institution is invested in IEX.  (Note – these allegations of undisclosed conflicts of interest by Yale are unconfirmed, but were told to me by insiders that have credible access to the information.) More important, the OpEd was completely wrong in how it depicts rebates as “kickbacks,” as well as numerous other flaws I have previously pointed out, making it a poor foundation for a serious investigation.

Rebates are a method for exchanges to attract more liquidity to be posted, and is particularly important in the U.S. market, where the tick size is one cent for all stocks, which often is insufficient for market makers to profitably provide liquidity.  It is critical to understand that rebates pose absolutely no conflicts of interest to liquidity providers such as market-makers and trading firms.  The only conflict of interests created by rebates is when agency brokers opt to pursue rebates to lower their cost of trading without disclosing that to their clients.  Interestingly, the retail brokers the Secretary sent letters to, do disclose where they route their client’s orders via rule 606

Having studied this issue in depth a few years ago, while running a wholesale market maker, I can also say that the retail brokers we studied averaged fill rates well over 95% (compared to aggressive definitions of what could have been executed) on the retail orders they sent to exchanges and not to market makers.  When one considers that the retail brokers we studied utilize the collected rebates to keep commissions low and provide services to their clients, we concluded their routing was likely in the best interests of their clients.  In addition, since all these retail brokers disclose where they route those orders, clients are free to decide whether their broker’s choices are reasonable.   (Note that I agree with the chorus of voices that express concern over institutional routing being potentially impacted by rebates.   This, however, does not change the fact that rebates are an important incentive for market makers to provide liquidity.)

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