Klein v TD Ameritrade threatens the broker-HST model

 “Give people who want something for nothing, nothing for something,” apocryphal mission statement for American con artists

Yes, America is truly the land of the free . . . free securities brokerage if you are a retail customer of many big companies. Strangely, large institutions, sophisticated individuals and rich families still pay for brokerage.

Perhaps they are stuck in the analogue era. Or maybe they know something that millions of retail brokerage customers do not. 

For example, professional investors will ask what is meant by “best execution” of securities and derivatives trades.

What it does not mean is the best price for selling or buying shares, futures or options at the moment the order is received by the originating broker.

Best execution covers a range of measures, such as the fastest execution, a better price than what is available as the “national best bid or offer” or, much of the time, execution by a third party off-exchange firm that pays the retail brokerage company for directing the retail order flow to them.

That third-party company, what would colloquially be known as a high-speed trader, “internalises” the broker’s flow of retail orders. It executes them at prices that may be better than most of the bids and offers shown on exchange screens, but which offer a slice of revenue, or something, to the recipient of the flow.

The revenue from this “payment for order flow” for the brokers is substantial. For TD Ameritrade, it came to $320m in 2017, up 7 per cent from 2017. E-Trade took in $135m, up 41 per cent from 2016. These are substantial fractions of their total revenues.

The buyers, which are highly sophisticated (and fast!) trading firms such as Citadel Securities and Two Sigma, can be assumed to have done better than break even on the differences between what they paid the brokers and what they realised from reselling the orders in the market.

There are, though, reasons why this symbiosis of brokers and high-frequency traders (HFTs) may end badly. The retail brokers have been assuming that the order flow payments borne by each individual small customer would be so small as to be not worth complaining about, let alone litigating over. They have also pointed to disclosures of order flow payments buried in the hundreds of pages of contractual and Securities Exchange Commission documents as proving they have nothing to hide.

Even so, over the years there have been lawsuits against brokers by customers claiming that payment for order flow created a conflict of interest so serious as to be a form of securities fraud. After all, the plaintiffs’ lawyers argued, since the orders were the customers' property, why should the profit from the sale be given to the broker and the HFTs?

For years those customer lawsuits went nowhere. They mostly faltered at the point where the customers’ lawyers tried to assert they were acting not only for the individuals they represented, but for the class of all customers who had the payments for order flow funnelled from their transactions. Such a class certification would be necessary to cover the substantial legal costs of claims against the brokers.

For years brokers’ lawyers and many judges assumed that complaints against payment for order flow could not be consolidated into class actions big enough to overcome the transaction costs of the lawsuits. So even if individual complaints were, indeed, supported by law, precedent and the facts, they would not be economically significant.

On September 14, though, that assumption was shattered in Nebraska in a case called Klein v TD Ameritrade. The court found that instead of requiring every single brokerage customer to prove harm from payment for order flow under the rule covering securities fraud, the losses for the entire class could be determined by “the same algorithm the defendant (TD Ameritrade) uses to route orders in the first place”.

This is big. If the court ultimately does determine that the customer class has been harmed, TD Ameritrade (and maybe other brokers accepting payment for order flow) could have to disgorge years of revenues from the practice, and, possibly, other penalties and charges.

If that happens, and the Klein v TD Ameritrade district court rulings are affirmed on appeal, it will be an existential blow to the current model for much of the retail brokerage industry in America. Not every company accepts payment for order flow but those that do are not sleeping soundly.

The court case, though, is not the only threat to the broker-HFT model. Official concerns about the systemic risks of these practices and their threat to resiliency has continued to bubble through the political and regulatory world.

Along with the suddenly increased legal threat to the HFT supply chain, there is more analytic evidence that the business model tends to accelerate herding behaviour and could amplify any sudden market moves. Those are fun on the way up but not on the way down.

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