Tuesday, July 15, 2014

Wall Street’s Maker-Taker Rebate: An Inherent Conflict of Interest

On June 14, 2014, the U.S. Senate Investigations Committee held a hearing on “High-Speed Stock Transactions and Insider Trading.” The issue at hand concerned the payments that wholesale brokers and exchanges make to brokers for going through the brokers and exchanges, respectively. An academic study had found that the broker or exchange that pays the most is not typically the most efficient, and thus in the best interest of the investor. Essentially, the payments give rise to a conflict of interest for the retail broker, who is supposed to put the client’s financial interest first, before his or her own. Is greater disclosure, such as Sen. Levin suggested, sufficient? I contend that a conflict of interest that is inherently unethical warrants removal rather than countervailing measures.   

Investors assume that exchanges such as the New York Stock Exchange are not tilting the game-board. Empirical evidence indicates that this assumption does not hold up. (Image Source: Reuters)

Thomas Farley, President of the New York Stock Exchange Group, testified that a conflict of interest is inherent in the maker-taker pricing schema. It results in a proliferation of order-types, he added, many of which exist solely to help market participants take advantage of the maker-taker spread. It is significant that a conflict of interest is inherent in the pricing itself, for the implication is that the entire schema is unethical. Put another way, even if an individual broker withstands the draw of the money, the system itself is blameworthy. This has wider implications for systemic conflicts of interest more generally; namely, they may be unethical even if no one has exploited them.

Even if there is not an actual conflict (i.e., being exploited) resulting in bad behavior, Farley explained, the appearance of conflict matters. “Markets rely on confidence,” he said. There may be an appearance in maker-taker pricing if a broker-dealer’s interests are not aligned with their customers. This can potentially arise with the pricing. There are examples where a broker-dealer has an incentive to post a price on a high make-rebate venue even if the execution quality at that particular venue is not as high as another venue. That arises specifically because of, or is certainly exacerbated because of maker-taking pricing. This is why there is a conflict inherent in it.

Farley’s reasoning is impeccable. The sheer appearance of a conflict of interest undermines trust, and thus confidence. Bradley Katsuyama of IEX focused on this point in explaining that the maker-taker rebate system is a significant issue because “it’s a principle-based issue. . . . It comes down to the foundation of why markets exist, and people’s trust in those markets. Trust is really about me saying that without me paying attention, the right things are happening in my best interest, and when you find out that they’re not, that’s what undermines it.” In other words, the investor-broker relationship is inherently compromised; just the chance of the conflict being exploited at the investor’s expense naturally prompts the client to look over his or her shoulder.

Unfortunately, as Sen. Levin noted, the average investor won’t make the judgment on best execution, so any suspicion would not find satisfaction. That is to say, the “buyer beware,” or caveat emptor, feature of the free market would not suffice to counter the harm inherent in the conflict of interest; greater disclosure and transparency, forced by the government, would be necessary. That is not to say that such a reform would necessarily happen. Even though Farley said, “We are seeking support for the elimination of maker-taker pricing,”[1] passing the legislation would mean taking on powerful (i.e., very wealthy) interests. As Katsuyama aptly pointed out,  “We’ve gotten a lot of anger from Wall Street. . . . People embedded in the status quo don’t want to see change happen.” In other words, people who profit by a conflict of interest naturally (but not ethically) protect it. This is another way of saying that it was likely being exploited. Indeed, such a likelihood is itself supportive of the claim that a structural or systemic conflict of interest is itself (i.e., inherently) unethical. To be sure, this is by no means a settled matter among the scholars on the topic.

Even in settling with greater disclosure as a sufficient remedy, rather than outlawing the price schema itself, Levin was either giving in to the political reality of a plurocratic (i.e., wealth-driven) political system or tacitly acknowledging that a conflict of interest that is inherently unethical is not so dire that it must be rooted out rather than merely countered. This is in essence what the folks who argue that conflicts of interest are unethical only when they are exploited are saying. In my view, they are understating the ethical problem, given the proclivity that human beings have to prefer their own self-preservation and enrichment over the interests of other people.

 1. Sarah Lynch, “Stock Exchange Pricing Model Comes under Fire at Senate Hearing,” Reuters, June 17, 2014.