Broker Routing Conflicts: Payments and Best Execution

The US Senate’s Permanent Subcommittee on Investigations was introduced to me two years ago as “the most powerful Committee that nobody’s ever heard of.” Today that Subcommittee, which is part of the Homeland Security and Government Affairs Committee is convening a hearing to examine conflicts-of-interest inherent in various forms of compensation for order flow, whether that be Payment for Order Flow (primarily used by retail brokers to divert orders to wholesalers / internalizers) or the Maker-Taker business model employed by the overwhelming majority of stock exchanges. KOR Group has long advocated for a trade-at rule and a pilot eliminating rebates, and both of these issues are focal points of the Healthy Markets Initiative. Healthy Markets brings together various participants in the industry to advocate for a common set of goals and beliefs.

We’re also excited to roll-out a new feature on our website that helps the public understand how brokers are routing their orders. This is a Sankey Flow Diagram, and it shows how various brokers route orders. For example, here is an illustration of 3 brokers – E*Trade, TD Ameritrade and Interactive Brokers. E*Trade and TD Ameritrade accept Payment For Order Flow – high-frequency internalization firms pay the brokers to send all marketable orders to them so they can be traded against proprietarily. Interactive Brokers does not accept any payments. These diagrams show a dramatic, and intuitive, difference. All order flow from E*Trade and TD Ameritrade is routed to high-frequency internalization firms, while Interactive Brokers orders are routed directly to stock exchanges over 90% of the time.


Here’s another chart that shows Schwab’s routing practices. For a firm that believes that HFT “is a growing cancer that needs to be addressed,” they have a long-standing contract in place with UBS in which they route 95% of their customer’s orders to UBS’s high-frequency trading group.


Comparing PFOF routing practices from E*Trade, TD Ameritrade and Schwab to the non-PFOF routing practices of Interactive Brokers begs the question – how can all of them be meeting their Best Execution obligations to their customers? In today’s Senate hearing, Professor Robert Battalio from Notre Dame will spend time discussing his research on this exact subject. His paper, “Can Brokers Have It All?” calls into question discount broker routing practices for non-marketable limit orders by showing that while brokers favor venues that give them the highest payments for their order flow (rebates in the Maker-Taker model), those same venues have inferior execution quality compared to venues that do not provide such levels of payments.

The same may be true when comparing routing practices for marketable orders. While KOR and Healthy Markets believe that the market and the price discovery process is damaged by the practice of internalization, it may also be true that by inhibiting competition with backroom, off-the-record handshake payment deals for retail order flow, discount brokers are not getting the best execution possible for their customers. This may also be why these same brokers refuse to make their data available for independent analysis and study.