Academics Explore Trade-Routing Relationships, See Investors at Disadvantage

A recent paper presented by academics from the University of Cincinnati and University of Notre Dame at a recent SEC conference, examines incentives behind trade routing relationships between institutional brokers and high-frequency traders and whether the institutional clients benefit from these relationships. Retail and institutional brokers commonly route their orders to high-frequency traders, allowing the brokers to directly receive payments from the traders on the basis of executed orders and the traders to profit from the spread between the fair value of the security and the transaction price -- a practice that has received considerable attention from regulators and academics. The authors note that institutional brokers may also route orders to high-frequency traders to obtain information about the value of a security, and for these types of order-routing the contracts between brokers and traders can be opaque. Indeed, certain of these arrangements have been targeted by state regulators. “Overall, this arrangement between the broker and the [high-frequency traders] seems mutually beneficial but it is not clear whether the investor whose orders are routed benefits from this relationship via lower transaction costs,” according to the authors. The academics say the paper’s findings have important implications for market structure. The “empirical evidence largely imply that these routing relationships between [high-frequency traders] and the brokers are not in the best interest of the investors as [high-frequency traders] appear to take advantage of the liquidity needs of the investors.” The authors add that their results could be beneficial to derive disclosure requirements for routing practices.