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Securities Regulators Are Inspired by an Academic Article to Seek Information Regarding Order Routing

Posted in Broker-Dealer Regulation, Enforcement, Fund Regulation

Apparently attempting to understand how broker-dealers provide best execution in the face of incentives to trade at certain exchanges, the SEC and FINRA are asking broker-dealers for extensive transaction information regarding how they route trades to exchanges.  By collecting this data, the regulators can monitor how firms, that have an incentive to trade with the exchanges offering the highest rebates, handle potential conflicts of interest with customers, who seek best execution. 

The regulators’ requests appear to grow out of an academic paper recently published by several academics at the Indiana University and University of Notre Dame business schools.

The authors of the paper point out that every U.S. stock exchange today either charges fees or pays rebates on orders based, in part, on whether they are market orders (and the exchanges earn revenue on the difference between the fees and the rebates).  Exchanges charge fees on market orders that take liquidity out of the marketplace and pay rebates on limit orders that supply liquidity to the market.  The paper concludes that brokers might route customer limit orders to the exchange that pays them the highest rebates, but that do not necessarily provide best execution on their trades. 

According to an article in the IU Bloomington Newsroom, the authors presented their paper to several broker-dealers and the SEC and FINRA, and the paper leaked out to the broader industry.  FINRA apparently viewed the paper’s revelations as significant, since it sent out a broad request to much of the industry – for routing data from 50 firms, according to the article.  It’s not clear whether FINRA is calling this a “sweep”; FINRA typically posts on its website its “Targeted Examination Letters,” except when it doesn’t; this is one of the “doesn’ts.”

Now we have learned that the SEC is making similar requests, using its inspection powers under Section 17(a) of the Exchange Act and issuing subpoenas.  Larger firms should anticipate that one or both of the securities regulators will be seeking their data, and we suggest that those firms that receive these invitations to provide data remain cognizant that there are many firms that were invited to the same party.  Many of these firms have discussed these requests with the regulators, and there are opportunities for seeking clarifications and further information from other firms or their counsel. 

We cannot predict where the regulators will take this inquiry, but firms drawn into it will only benefit from having as much information as possible.