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February 1, 2005

Discounting or Deception? Like Death and Taxes, Payment for Order Flow Goes On and On

By Mark Longo

Still, technology could catch up with the deceptive practices. For instance, the recent electronic linkages between the exchanges seem to have helped reduce the payment arrangements. However, this reduction is not enough to quiet the critics. Some of these critics have sent the Securities and Exchange Commission examples of brokers allegedly violating their fiduciary responsibility in return for actual cash payments. Unfortunately, the SEC has been slow to issue a firm ruling in this controversial area, some of these critics charge.

"This is so deeply imbedded in our business that, absent something that is really earth-moving, whether it is Mr. Spitzer or somebody else, I don't think there is going to be a lot of change, because the SEC doesn't feel that they have the capability," says Bill Brodsky, Chairman and CEO of the Chicago Board Options Exchange.

Brodsky compared attempts at eliminating payment for order flow to putting your finger on a balloon. "You press on one side and something is going to come out the other side," he says.

The SEC says it is aware of the issue. John Heine, a spokesman, pointed out to Traders Magazine that the agency published a concept release examining payment for order flow, about 12 months ago. And it then followed up with some specific recommendations.

In an earlier study, the SEC's Office of Compliance Inspections and Examinations concluded that payment for order flow did influence where trades were routed. However, brokerage firms were not passing along the benefits to investors, according to the SEC study.

The critics of payment for order flow are not satisfied. "The SEC feels that they've addressed the issue by disclosure, but they have actually done a very poor job in dealing with the issue," says Brodsky. However, banning payment for order flow is like tilting at windmills. "Any time there are multiple manufacturers trying to sell product down a limited number of distribution channels, there are going to be incentives offered," says Kenneth Leibler, Chairman and CEO of the Boston Options Exchange. Leibler says the BOX is exceptional because it does not "pay" for orders. His competition is presumably paying attention. But Leibler admits, "I don't think that you will ever eliminate these incentives."

Frucher, who agrees, says, "What you really have to do is define it, control it and make sure it's transparent."

The issue of transparency has become problematic. Many firms and exchanges know how to dress up the incentives. Payments of cash are frequently compounded with other, less explicit incentives. One popular method is to allow brokerage houses to cross, or internalize, a larger percentage of volume. This allows brokerages to gain double commissions and generate position profits without any cash changing hands. The combination of internalization with direct payment has likely hampered the SEC from issuing a cast iron rule banning, or dramatically curbing, payment for order flow.

"Part of the problem is that the SEC has been unable to differentiate these things sufficiently," says Brodsky. He says the SEC, for example, is unable to legally separate out the differences between tickets to a ballgame and internalization.