New Academic Paper Is the Equivalent of ’94 Christie-Schultz Study


We have often been asked if we could do one thing to fix our market structure problems, what would it be?  The answer is undoubtedly to get rid of payment for order flow which includes the exchange maker/taker model.  We have long felt that payment for order flow corrupts order routing decisions and hurts the price discovery process.  We have often pointed to 606 reports as evidence that some very large retail brokers are selling their flow to the highest bidder.  But what we have not been able to do was to link this sale of order flow to poor execution quality – up until now.

A new academic paper titled  “Can Brokers Have it all? On the Relation between Make Take Fees & Limit Order Execution Quality”  by Battalio, Corwin and Jennings proves our theory.

After an exhaustive academic analysis using proprietary limit order data and NYSE Trade and Quote data, the authors concluded:

Routing limit orders in a manner that maximizes make rebates reduces fill rates and produces less profitable limit order executions.  Routing orders to maximize rebates might be inconsistent with a broker’s fiduciary responsibility to obtain best execution.”

What makes this study even more interesting and revealing is that the authors name names:

We provide the first empirical analysis of the relation between order flow rebates/fees and limit order execution quality. We show that several national brokerages made routing decisions in 4Q2012 that appear to be consistent with the objective of maximizing order flow rebates.  We present evidence that Ameritrade, E*Trade, Scott Trade, and Fidelity make order routing decisions in the 4th quarter of 2012 that appear to maximize the liquidity rebates generated from limit order executions.”

“We present evidence that suggests limit orders routed to venues with lower liquidity rebates are executed faster and more frequently. We also show that, on average, limit orders executed on venues with low/negative take fees generate higher average and median realized spreads. Finally, even if fees/rebates are passed directly through to the investor, the decision to use a single venue that offers the highest liquidity rebates does not appear to be consistent with the objective of obtaining best execution.”

The authors also ran so-called “horse races” where they examine execution quality of exchanges with different fee structures and found that:

“Limit order execution quality is inversely related to the relative level of make/take fees. Our results also suggest that the commonly used strategy of using EDGX as the sole venue to display limit orders results in diminished execution quality.”

This paper is a groundbreaking study that should warrant immediate regulatory review.  We view this paper similar to the 1994 Christie-Schultz study which theorized that NASDAQ market makers avoided quoting in odd eighths to artificially keep the spreads wide.  Regulators need to start acting to protect investors from these back door, payment for order flow schemes.  While advocates of our current market structure often tout “tight spreads” and “$8 retail commissions” as signs of market quality, this paper proves those arguments to be false.  The current Rube Goldberg order routing model, which took a simple task and made it overly complex, is actually hurting investors.

Our recommendation is that the SEC should propose a pilot program immediately which bans payment for order flow  in all forms. Order execution quality could then be measured for those stocks in the pilot program.  Based on the evidence in  this new paper, we are confident that the orders executed in stocks that are in the pilot program would outperform the payment for order flow stocks.