News Column

IU professor's stock market research ruffles finance feathers

February 23, 2014

By Rick Seltzer, Herald-Times, Bloomington, Ind.

Feb. 23--This is a story about an academic paper on the financial industry, but it's not filled with tweed suits or dizzying numbers.

It involves brokers grabbing money. Investors missing out on trades. Leaked research co-authored by an Indiana University professor.

The research was cited in recent public remarks by a commissioner of the U.S. Securities and Exchange Commission. And its authors think it could play into a move by the Financial Industry Regulatory Authority to ask for data from the country's 50 largest brokers.

To understand the research, though, you have to brush up on just a few watered-down details about the world of securities. There are more than a dozen securities exchanges in the United States -- places like the New York Stock Exchange, where stocks are traded.

They're all competing for a type of order called a limit order. Exchanges offer rebates on limit orders, which are basically instructions to buy or sell shares in a stock when it hits a certain price.

Brokers, who go between investors and exchanges, route limit orders. And they tend to route investors' limit orders to exchanges that offer high rebates, according to a research paper by the IU professor and two University of Notre Dame professors.

Here's where things get controversial. The paper argues that routing orders to get the most rebates might not be in customers' best interests.

"The broker has an incentive that doesn't necessarily align 100 percent with the customer," said Robert Jennings, a professor of finance at IU's Kelley School of Business who co-authored the paper. "We find limit orders have lower execution the higher the fee.

"There are certain circumstances where the limit order on a high-fee venue won't get filled," he said. "By sending it to the exchange that charges more, your broker is pushing you down the queue, in essence."

The research stirred controversy earlier than its authors expected. They circulated it to members of the financial industry before it was published in an attempt to get feedback for revisions before publishing.

One of the authors, Notre Dame finance professor Robert Battalio, presented the data in December during a swing through the New York City area. Then he received a phone call telling him the paper had been leaked and a link to it was posted on Twitter.

The paper authors don't know who leaked their research without their permission. They have suspicions, but aren't sharing them.

"We suspect it was an institution, so they could brag about how good they looked," Jennings said.

The research caused a stir in some financial circles. One exchange leader engaged in a lengthy back-and-forth on Twitter with Battalio over it. Three brokerage firms told The Wall Street Journal they disagree with the findings.

At the beginning of February, SEC commissioner Kara M. Stein referenced the paper in remarks before the Trader Forum 2014 Equity Trading Summit in New York City.

"Do these routers send orders to the venues that are most likely to get them filled?" she said, according to a transcript. "Or do they send the orders to the venues that have the lowest cost for the broker, even if it might not get the order filled, or get the best price?"

The research could also come into play in some Financial Industry Regulatory Authority action, Battalio said.

"FINRA is doing a brokerage sweep to just investigate routing practices," he said. "I think it's fair to say this has raised issues that they maybe want to go out and check."

The paper's authors, who also include Notre Dame professor Shane Corwin, still want to have the paper published in a top peer-reviewed outlet. They've made revisions to it since it was leaked, just as they would have had it never hit the Web. They're also planning to present it to industry groups.

"Is this a disaster?" Battalio said. "No. But it's not right. Brokers are supposed to have best execution for their clients in mind."


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