David Swensen, the head of Yale University’s $US22 billion endowment is calling out some of the biggest players in finance for shelling out billions of dollar for what he calls “kickbacks” to attract business to their trading venues.
In a joint op-ed in the New York Times, Swensen, a former Wall Streeter, and Jonathan Macey, a professor of securities law at Yale, said trades are supposed to be executed on the exchange that offers the lowest price and quickest transaction time.
“But that’s not what is happening,” Macey and Swensen wrote.
That’s because exchanges such as the New York Stock Exchange and Nasdaq pay rebates to brokers, the folks who buy stocks for their clients, to incentivise them to send their orders to their exchange venue. According to Macey and Swensen, brokers frequently send their orders on the exchange where they are offered a rebate, rather than where it would be done the most efficiently.
“As a result, the brokers produce worse outcomes for their institutional investor clients — and therefore, for individual pension beneficiaries, mutual fund investors and insurance policy holders — and ill-gotten gains for the brokers,” Macey and Swensen concluded.
IEX, which gained exchange status last June, has “refused” to pay rebates to brokers, according to Macey and Swensen. Yale has a small indirect investment in IEX. The firm’s CEO, Brad Katsuyama, came down hard on practice in late June during the House Financial Services Committee’s US Equity Market Structure hearing. Here’s Katsuyama (emphasis added):
In short, rebate practices cause clear and significant harm to investors. In addition, they are inextricably linked to much complex regulation that, although designed to serve the interests of investors, has had unintended consequences and could be reduced or eliminated if this conflict is removed.
IEX offers tighter spreads on stocks, according to Swensen and Macey, who said IEX provides the best spreads for 497 stocks in the S&P 500.
Some folks on the Hill are calling on the SEC to take further action, however. On July 14, Virginia Senator Mark Warner, a Democrat, called for the complete elimination of rebates in a letter to the newly confirmed chairman of the Securities and Exchange Commission.
“These reforms would help to strengthen alignment – rather than conflicts – of interest between brokers and clients, increase price transparency, reduce fragmentation, strengthen stability, and bring US equity markets closers to the competition mandate required by Securities Acts Amendments of 1975,” Warner wrote.
The Securities and Exchange Commission may implement a “pilot program” that would examine the degree to which rebates affect the markets.
The exchanges view rebates in a different light.
Responding to IEX’s Katsuyama on the matter, for instance, CBOE President and COO Chris Concannon said:”This notion of banning rebates — it lacks understanding of how our market works.”
Concannon said the majority of rebates go to buyers, not brokers, in order to incentivise them to provide liquidity for small companies and ETFs that don’t draw enough interest from the markets.
“Let me continue by saying that when brokers receive rebates, they are still subject to best execution,” Concannon added.