In institutional equity trading, rebates have been a point of contention since the late 1990s, when Bill Clinton was U.S. President and the Dow Jones Industrial Average scaled 10,000 for the first time.

Supporters say exchanges paying rebates on order flow is a perfectly legitimate practice of rewarding customers and offering volume discounts. Critics say rebates create conflicts of interest, and shortchange end investors if brokers route in ways that disadvantages clients.

One aggravating factor is a lack of transparency. Many market participants do not know either the amount of the rebate or where it ends up. Full disclosure of this information would effectively resolve the issues, according to Stino Milito, Co-Chief Operating Officer at Dash Financial Technologies.

“Rebates themselves aren’t a bad thing. When used properly they lower – sometimes drastically – transaction costs for clients and switching to a cost-plus model when possible better aligns the interests of the broker and the client,” Milito said. “But the issues arise if brokers aren’t using them in their client’s best interest. If brokers are willing to show how and why they’ve routed a client’s orders the way they have, this becomes a non-issue overnight, and managers should demand access to real-time order routing details, regardless of the pricing policy they have in place.”

In the wake of the global financial crisis of almost a decade ago, the buy side has been pressed to show more information and data to its own clients, and in turn asset managers have demanded a similar level of openness from the brokers who handle their trade orders.

“Our internal trade analysis suggests that execution quality may be negatively impacted when broker-dealers’ routing decisions are made to minimize access fees,” which exchanges use to subsidize rebates, Capital Group Global Equity Trading Manager Matt Lyons co-wrote in a May 31 comment letter to the U.S. Securities and Exchange Commission. “Moreover, the market has seen numerous cases of inadequate disclosures and improper arrangements made between market makers and ATSs that may disadvantage institutional clients.”

Helped by rebates, trading commissions have dropped substantially over the years; the biggest decline from 2005 to 2017 was 68% for the lowest-touch direct market access / algorithmic trades, according to Tabb Group research. That’s an impressive headline number, but there are questions around other, less explicit costs that combined with commissions, comprise the total cost of execution.

“There is a huge appetite for more transparency from the buy side,” Milito told Markets Media. “Most buy-side firms operate with ‘all-in’ pricing models and aren’t provided granularity into fees by order, but the decisions on when and how to route to particular venues significantly impact execution performance. Transparency immediately adds clarity to the rebate, but it is the information that you can learn from this data that helps shape performance to the buy side’s specific needs that we find more valuable.”

The SEC in March proposed a transaction fee pilot program, which Commissioner Jay Clayton said is meant to generate “information to facilitate an informed, data-driven discussion about transaction fees and rebates and their impact on order routing behavior, execution quality, and market quality in general.”

Regulators are well-intentioned in seeking more data, but the pilot program is likely to fail because of systemic opacity in the marketplace. That’s the opinion of Dave Weisberger, Head of Equities at ViableMkts.

“There is absolutely crap disclosure about broker-dealer routing strategies,” Weisberger said. “If you can’t get a high-level view of how brokers route and what the outcomes are, then how can you be talking about a transaction fee pilot, or making claims about what rebates do to destroy the market?”

“You need to have transparency first, or the study itself will prove nothing,” Weisberger said.

Ultimately, market forces, rather than regulatory fiat, are what’s likely to drive change, as innovative firms who supply this level transparency, customization and analysis will grow at the expense of those who can’t or choose not to.

“Real-time, comprehensive transparency and routing analytics are key components for tailoring performance to individual preference,” Dash’s Milito said. “Fortunately, for firms wishing to modernize and improve their execution performance, these tools already exist. At Dash we believe strongly that they are on their way to becoming the new normal.”