by Kyle Colona on July 3, 2012
A recent report by independent consultant Woodbine Associates reveals how the practice of market exchanges paying rebates to brokers is a conflict of interest.
Similar to the problem of market raters being paid by financial firms for their credit ratings of debt offerings, stock exchanges have been paying broker-dealers so called rebates in exchange for business volume. While today’s market environment where exchanges are publicly traded entities is forcing exchanges to make profits, the profit motive is a booby trapped laden road.
In fact, in the wake of the Facebook IPO fiasco, the SEC’s enforcement unit has opened more than a dozen related cases to determine whether exchanges lack adequate controls and favor select investors.
Critics of these exchange rebates argue that they give brokers an incentive to profit at the expense of other investors. And the Woodbine report concludes that rebates might be costing funds and ordinary investors almost 5 billion$/year!
The New York Times said that this study also revealed how rebate payments are often connected to “high frequency” trades. And such trades are increasingly being made in the exchange traded funds (ETF) sector. This sector, moreover, has often been pitched as a safe harbor for 401(k) investors looking to diversify their investment portfolios.
But if you connect the dots between automated trading practices to the rebates being paid to firms, it looks like a huge loophole that could throw the door open to legal and regulatory actions across the market place. And that’s only one of the dangers of the rebate practice.
Moreover, offering “rebates” is a potential conflict of interest because exchanges may be inclined to favor select investors over others. And this is the overarching issue being examined by the SEC in the Facebook matter.
While the SEC can ban the practice the Street would push back because federal authorities should not have the broad power to set prices in a free market place. But it’s a different matter when a rebate could morph into a kickback or some other nefarious quid pro quo.
However, as the Times story notes the rules governing rebates are complex, but they aim to ensure that no one exchange has a regular edge. At the same time, brokers constantly “tweak” their programs to ensure they are paying the lowest possible prices to execute customer trades, while receiving rebate premiums. And if the Woodbine report is accurate, $5billion/year in exchange rebates could become a big legal/regulatory headache.
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Kyle Colona is a New York-based freelance writer and a Feature Writer forCompliancEX> and the Wall Street Job Report. He has an extensive background in legal and regulatory affairs in the financial services sector and his work has appeared in a variety of print and on-line publications. You can find him on linkedin.