Perspective: Time for Brokers, Investors and Regulators to Align

The SEC has the brokerage industry in its crosshairs again. Can't we go a week without another inquiry, scandal or front-page disaster? Just this week the SEC announced it is investigating a dozen brokers for violating best execution regulations for retail investors. Last week it was the GAO report on business continuity, the week prior it was insurance, the week before that, banking, and the year before that, it was mutual funds.

Will this ever stop? Has the compliance steamroller just gained too much momentum, or are financial services firms worse than Al Capone during Prohibition? Hopefully it's the former and not the latter, but with the headlines these days, who can tell?

The latest scandal is about a number of firms that were found to have executed retail orders away from the market. The two singled out practices are perennial compliance bad-boy practices: internalization and payment for order flow.

Internalization occurs when brokers' match orders against internally offsetting trading flow without exposing the order to the public (an exchange or ATS). Payment for order flow involves an introducing broker selling its order flow to an executing broker that matches it at a less-than-advantageous price. The underlying processes of internalization and payment for order flow are legal; however, matching the order at less than the best market price, of course, is not.

These investigations come at a horrendous time for the equity markets. The execution business is hurting as decimalization has reduced spreads. Not only are spreads down, but commissions are under siege as algorithmic trading has automated block execution, and direct market access/aggregation has enabled buy-side firms to reduce commissions by taking a more active role in the trading process. The risk of the proprietary-trading business is also suffering as model-driven trading has made it more difficult to find, capture and profit from trading opportunities. Not only is the trading business down, but the demand-generation business is also in the tank as the research settlement devalued research, and while equity origination or initial public offerings are nowhere near their 2000 levels.

What's a broker to do? Brokers these days are in between the proverbial rock and a hard-place. They can't make money executing, trading or internalizing their order flow, and they can't even sell it. Increasing commissions seems to be a non-starter. Brokers are even finding it difficult to generate demand, as broker research is tarnished, and the IPO/origination business hasn't come back since the Millennium.

This pushes the market in only one very clear direction: toward extreme automation. Not only developing a totally hands-off STP-enabled processing environment for the back-office but a completely hands off front-office process as well. Firms will need to build completely automated order routing, execution, and transaction analytics environment where rule-based engines virtually take over the business. These engines will need not just to automatically route an order to market, but they will need complex, smart order-routing facilities that will know for each stock, time and trading pattern exactly how to split, route, execute and benchmark each execution.

This automation will not stop at the trading desk. In conjunction with execution, firms will also need to provide an audit trail of each execution and the associated decision factors and benchmark, performance, profitability and opportunity cost of each transaction. Each of these factors will need to be vetted, analyzed, collated and stored to insure that virtually no exception, human instinct or variability impacts the execution.

Sounds like the utopian world: a Stepford Wives for the equity trading set where all traders are replaced with computers, and all the human decisions factors are replaced with pre-determined rules. Actually it sounds pretty horrible, where intellect, intuition and excitement is replaced by rule, algorithm and high-speed bandwidth.

This vision for retail investors may take years to build, yet it seems that regulators and litigators want this tomorrow. While these changes may make the brokerage industry look more like the high volumes/low-cost payments industry, it may finally be the impetus to align the industry, its clients and the regulatory authorities without "going to the mattresses." That would be a battle the industry is not well positioned to win.

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