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February 1, 2012

Cover Story: Full Disclosure

By James Armstrong and John D'Antona Jr.

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"Ultimately, it's about whether brokers are routing order flow for their benefit or for the client," Goeller said. "Is the broker routing to an exchange for their economic benefit, or are they routing to the exchange which provides the best execution?"

Best Ex or Best Price  

John Goeller, BoA

While the buyside wants best execution, the sellside wants to keep costs to a bare minimum-which often means routing orders first to their own dark pools, and only as a last resort sending orders to exchanges and paying fees. This has the potential to pit the interests of the buyside against those of the broker.

Invesco's Cronin said that when brokers prioritize how to route orders, they look first and foremost at economics.

"This business is about managing conflict and this is a conflict we have to pay attention to," he said. "I'm absolutely concerned where my order goes."

In Cronin's view, brokers will send orders first to dark pools and give preference to their own systems, which cost nothing. Then if an order requires further routing, it goes to the venue where the broker gets the most favorable economic outcome. This is where a potential conflict of interests can arise - is the best price for the broker taking precedence over the best fill for the client?

"If you're a firm that has seen its commissions squeezed, then you as a broker are going to consider the economics of getting the rebate very carefully," Cronin said.

A recent study by Pragma Securities found that routing behavior is influenced by fee structures, with brokers tending to prefer cheaper venues when price is held equal.

David Mechner, chief executive officer of Pragma, said buyside firms are trying to get more transparency given that a broker's agenda might not be perfectly lined up with their own.

Such concerns have been heightened in the post-Pipeline world. Last October, regulators alleged Pipeline Trading Systems failed to disclose that at times more than 97 percent of orders in its dark pool were filled by a trading operation affiliated with the firm. While the firm settled the charges last year, buysiders remain cautious as to where their orders are going and why.

"Especially after the Pipeline incident, people are reminded of the fact that there's not a lot of transparency," Mechner said. "Things are not always well just because they're out of sight and out of mind." 

Part of the problem is that as brokers shop around for best price, an order can be exposed to multiple venues. That increases the chance the order will be pinged by high-frequency traders, creating the potential for information leakage and slippage in price.