The Permanent Subcommittee on Investigations (PSI), chaired by Senator Carl Levin (D-MI) will hold a hearing on June 17th on “Conflicts of Interest, Investor Loss of Confidence and High Speed Trading in U.S. Stock Markets”.
In particular, the subcommittee “will focus on the conflicts of interest that arise between the obligation of brokers to provide the customers with best execution of their orders to buy or sell securities, and the brokers’ receipt of payments from other brokers for order flow and rebates from some trading venues for placing those orders directly.”
We will submit six recommendations, for additional research, to Senator Levin’s Committee for the June 17, 2014 Hearing on potential conflicts of interest impacting retirement investors.
As an retirement investor advocate, The Derivative Project believes the rapid shift to online discretionary management of retirement accounts in ETF’s and order flows that derive from such new models is a substantial new risk to retirement investors today. As a Stanford University white paper cited in 2011, “Do Dark Pools Harm Price Discovery” “higher volumes of dark trading lead to wider spreads and higher price impacts on exchanges.” Thus, without the knowledge to agree or disagree on the role of dark pools on price discovery, we do however believe the conclusion of this paper is that “higher volumes of dark trading lead to wider spreads and higher price impacts” is significant factor to be addressed.
This finding has a direct correlation on the process that new models are using to clear, execute and provide custody for retirement assets in online discretionary managed ETF portfolios.
The name of the game for electronic exchanges is order flow and volume. Yes, where is there a significant new source of volume? As a recent McKinsey study reported:
“In fact, far from declining, our research shows the size of the DC market is likely to double by 2015, to reach roughly $7.5 trillion to $8.5 trillion in assets under management (AUM). Even more striking, DC will become three times larger than the market for private defined benefit (DB) pensions. Plan providers, asset managers, and retail financial advisors/wealth managers, among others, will enjoy access to a revenue pool projected at $20 billion to $25 billion for the mega 401(k) plan seg- ment alone. Massive flows from DC into IRAs will create further opportunities for integrated players and wealth managers among others.”
Two of the largest new online ETF services, Wealthfront and Betterment, both use APEX for clearing, execution and custody*. These two services (and other comparable ones) must be looked at by the Permanent Subcommittee in entirety as to the systemic risks posed by execution, clearing and custody without (1) separation of function (2) lack of price discovery and (3) lack of any published performance figures, after all trading costs, for the retirement investor.
Are there concerns about potential risks for retirement investors, through the lack of segregation of function and payment for order flow, combined with HFT and dark pools, that may create a new instability, such as exhibited during the May 6, 2010 Flash Crash?
Further the retirement investor has no recourse to protect retirement assets when there exists severe market instability, as exhibited during the May 6, 2010 Flash Crash, when self-directed firms, such as Charles Schwab prohibited small retirement investors from trading, but allowed institutional clients and RIA’s to continue trading.
New Online Discretionary Investment Management Firms, such as Wealthfront, Explicitly State They Have No Responsibility for Conflicts and Price Execution
Here is an excerpt from Wealthfront’s customer agreement, for retirement investors (and non-retirement ):
Wealthfront identifies significant potential conflicts of interest in trade execution, as the excerpt from their Agreement specifies below. Although one is not paying any specified trading commissions, the costs to the retirement investor, based on payment for order flow and actual price execution, could be far greater, than through a traditional regulated exchange:
(1) “Wealthfront shall not have any responsibility for obtaining for the Account the best prices or any particular commission rates. Client recognizes that Client may not obtain rates as low as it might otherwise obtain if Wealthfront had discretion to select broker‐dealers other than Broker.”
(2) “Client recognizes that Wealthfront or its affiliates may receive commissions, and have a potentially conflicting division of loyalties and responsibilities regarding, both parties to such Agency Cross Transactions.”
(3) “Nothing in this document is intended to provide a guarantee or warranty regarding the actions or performance of Apex Clearing Corp., its computer systems, or its personnel in the event of a significant disruption.”
(4) “13. Payment for Order Flow Disclosure. Depending on the security traded and absent specific direction from the Customer, equity and option orders are routed to market centers (i.e., broker‐dealers, primary exchanges or electronic communication networks) for execution. Routing decisions are based on a number of factors including the size of the order, the opportunity for price improvement and the quality of order executions, and decisions are regularly reviewed to ensure the duty of best execution is met. Apex or Wealthfront may receive compensation or other consideration for the placing of orders with market centers for execution. The amount of the compensation depends on the agreement reached with each venue. The source and nature of compensation relating to the undersigned’s transactions will be furnished upon written request.”
In sum, online investment management firms, such as Wealthfront, Motif and Betterment*, are all using APEX for clearing, execution and custody*. Volumes of retirement assets in ETF’s will be routed through a custodian that has less than two years experience as its current entity and derived from a bankrupt entity. Through retirement asset volume being routed through a relatively new firm, with no prior experience in custody of retail retirement assets, and with the ability for these firms to pledge and hypothecate client assets, what additional safeguards should there be for retirement investors? Should these firms have greater capital requirements if they trade in dark pools with retirement assets?
The Singular goal of the new online investment management firms is volume. It is clear, if off-exchanges and HFT traders will pay them for “volume” they will deliver it. It is an easy model – slap an assets under management fee on a few ETF’s and then direct the flow to HFT traders, for payment. The more AUM, the more profit. It is a win for the non-transparent exchanges and the new “online investment management firms”. The retirement investor loses, through performance that under performs the relevant indices, after management fees and trading costs.
Recommendations Number Three, Four, Five and Six for the June 17th Hearing (see one and two here)
(3) Ascertain the impact of retirement dollars being priced in dark pools, payment for order flow to off exchange entities and the potential costs of HFT to these accounts:
Should American’s retirement dollars be prohibited from being traded on other than regular exchanges, with bona-fide price discovery? Why or why not?
(4) Should the investment management function, of new online firms, be segregated from the ability of firms to make profits from off-exchange trading which is the new investment management model of new online trading venues?
Betterment and Wealthfront, for example, have set-up brokerage firms to not only profit on investment management, but now serve to create a new profit model by providing trading volumes to potentially dark pools and HFT, through their ETF only “investment management” firm by delivering regular large size blocks through rebalancing and ongoing new clients.
With projections of over $8.5 trillion in DC plan assets and over $5 trillion in IRA assets, by 2015, this represents a significant market — a steady stream of volume to fuel HFT, dark pools and non-transparent exchanges, at what cost to American’s retirement nest eggs?
(5) What protections should there be for retirement investors when HFT may limit access for retirement investors, such as it did on May 6, 2010? Please read here the standard language for brokerage firms that use off exchange trading, that limits recourse to the retirement investor, from Betterment’s Customer Agreement, dated June 10, 2014:
“Further, access to the Website, and hence, the Account, may be limited or unavailable due to, among other things: market volatility, peak demand, systems upgrades, maintenance, any kind of interruption of the services provided by Betterment Securities or Betterment’s ability to communicate with Betterment Securities, hardware or software malfunction or failure, internet service failure or unavailability, the actions of any governmental, judicial, or regulatory body, and force majeure. Client agrees that neither Betterment nor Betterment Securities will be liable to Client for any Losses incurred by Client (including, but not limited to, lost profits, trading losses, and similar damages) resulting from such access limitations or unavailability.”
(6) Mutual funds, organized under the Investment Company Act of 1940, must file regular performance, all fees, trading turnover percentages, for example, with the SEC on a regular basis. New online “investment firms” and other managed accounts, that trade exclusively in ETF’s and offer a steady stream of volume to “electronic exchanges” have no responsibility to file performance results with the SEC.
Should new online investment management firms, and managed accounts in DC plans, that exclusively trade and invest in ETF’s and provide block trades for non-regulated exchanges and no price discovery) be responsible for organizing under the Investment Company Act of 1940, to ensure performance reporting, after all trading fees? Why or why not?
Retirement Investors that Use Online Investment Management Firms that Execute through off Exchanges are in the Dark on Trading Costs and True Performance Results
Is it not a major conflict that the retirement investor has no idea of their true performance; yet they are told they are paying no trading fees, but must simultaneously agree to blind execution that may provide adverse results? Are there hidden “trading” fees, in these accounts that ostensibly charge nothing for custody, clearing and trading? The retirement investor, that trades with firms executing in these markets, are not only in the dark on trading costs, but are in the dark for overall portfolio performance, after all fees.
Confidence in our markets has never been lower. We reiterate, retirement assets mandate bona fide transparency for trading costs/portfolio turnover and must be traded, cleared and safe kept by firms that have years of performance as true fiduciaries. The costs to society are too great to act otherwise.
*Exception: Betterment is using a custodian in Albuquerque New Mexico, Sun West Trust Inc, for IRA custody. If there are any issues in the account, the client is forced to go to the Albuquerque courts for resolution and to agree to the statement in the Betterment Agreement, “I acknowledge that I have sole responsibility for directing the investments of my Account”, when this is a discretionary account( Betterment’s June 10 Client Agreement states all its accounts are switching from non-discretionary to discretionary, with only 30 days notice) managed by Betterment. It seems to be the wild west out there in online investment management—one day it is a non-discretionary investment management system and the next day, with no explanation it is changed to a “discretionary” investment management account.