NEW YORK, Feb 2 (Reuters) - U.S. retail brokers, looking to combat claims that they fail to get the best possible prices on trades for their mom-and-pop customers, plan to give clients more information about how their trades are executed.
Regulators at the U.S. Securities and Exchange Commission are looking at whether discount brokers have conflicts that result in individual investors missing the best possible deal when buying or selling shares.
The potential conflicts stem from payments that brokers receive from the market makers that are ultimately buying shares from or selling to individual investors. Critics say those payments may encourage retail brokers to send orders to whichever market maker is willing to pay the broker the highest price, even if the investor could have gotten a better deal elsewhere.
Most brokerages do not disclose the size of the payments they receive, but TD Ameritrade said it took in $304 million from the practice in 2014, up 29 percent from the year before.
The payments are legal and retail brokerages say they benefit customers because they help keep commissions low. Full-priced brokerages like Morgan Stanley generally charge higher commissions and do not accept these payments.
Now a group including TD Ameritrade, Charles Schwab Corp and Fidelity Investments hopes to ease concerns about conflicts by giving investors more detailed reports including how much money on average they saved the customer by executing their trade a particular way, and the average speed at which the orders were executed.
The brokerages, which make hundreds of thousands of trades a day for retail investors, confirmed these plans to Reuters, which have not previously been disclosed. The voluntary effort will help the SEC in its review on order routing, TD Ameritrade Chief Executive Fred Tomczyk said in an interview.
The fact that brokers are making this effort voluntarily shows how concerned they are about the appearance of a conflict of interest, and the SEC probe they face. The SEC has said it is looking at requiring brokers to disclose more about how they are routing trades, and brokers hope their efforts will eliminate the need for new regulation.
The Financial Information Forum, a securities industry trade group, is leading the effort to standardize and simplify the reports that some brokers already provide. The information is expected to be included in customers' brokerage statements.
The payments that brokers receive have risen dramatically over the past decade, while commissions have remained largely unchanged, said Dave Lauer, president of market structure consulting firm KOR Group LLC, which advocates for reform of order execution disclosure rules.
Payment for order flow is a clear conflict of interest, he said. "And if you are not going to get rid of that conflict of interest, then you have to disclose it appropriately and sufficiently, and they haven't done that," he said of the retail brokerages.
If investors had more and better information about what happens when they trade, they could make better decisions about which brokers to use, Lauer said.
Order routing can influence the prices that institutional investors receive too, an idea explored in Michael Lewis' 2014 book "Flash Boys: A Wall Street Revolt."
Wholesale market makers are willing to pay to trade with retail stock investors because executing those trades can bring a tidy profit. The market makers pay for the right to trade with investors, and then try to match buyers and sellers without going to exchanges, pocketing the difference between the price at which they can buy and sell.
If the stock price moves in the wrong direction, before the market maker can match the shares, the profits evaporate. Retail investors do not tend to make market-moving trades, unlike institutional investors, so the market maker has a better chance of profiting.
It is difficult to determine how much harm, if any, the payments from market makers cause investors. By law, brokers must give a customer a price at least as good as the best price quoted by major stock exchanges.
But if a customer is looking to buy shares, and a broker has to choose between two market makers, the broker may choose the market maker that it receives the highest payments from, instead of the lowest possible price for the investor-in particular, the market maker offering the biggest discount on the best price quoted by an exchange.
Researchers from the University of Notre Dame and Indiana University have suggested that a small segment of retail orders - those with instructions to be executed at a particular price - may indeed be harmed by "payment for order flow" practices. Those investors, they say, may miss out on profitable trading because their orders are not necessarily routed to the best possible venue.
But the vast majority of retail investors - those who want their trades executed immediately - actually benefit from the financial relationships between their brokers and market makers, said Robert Battalio, a professor at Notre Dame who co-authored the study.
That's because the market makers buy the orders from the brokers at a price at least as good as can be found on any public exchange, immediately locking in the price the investor sees.
If the order were sent directly to an exchange, the order would be put in a queue based on when it arrived, and the price could move in an unfavorable direction before the order is executed. (Reporting by John McCrank and Jed Horowitz. Editing by Dan Wilchins and John Pickering)