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Another Way Brokers Make Money Without You Knowing

Your broker might be earning extra pennies, but those extra pennies could end up costing you extra dollars.

Those pennies are coming from a source most investors might not expect. It’s not a fee, or a sales commission. It’s a payment from a stock exchange…in return for sending business their way. These payments, known as rebates, have become more prevalent as exchanges battle for business. Today, all 13 of the country’s exchanges have some sort of rebate program. Nasdaq paid out $306 million in rebates in the first quarter this year (which amounts to close to half of its revenue, according to the New York Times).

On the surface, a rebate might not seem like something investors should worry too much about. And in a perfect world, it would be nothing to worry about. If an exchange gives a little incentive to a broker to execute a trade, it wouldn’t matter if that still meant that brokers were making sure that investors were getting the best possible price.

But that’s not happening. Rebates give brokers an incentive to send trades to the exchange that offer the highest payment…not necessarily the exchange that has the best price for the investor.

And the pennies add up. Rebates could cost mutual funds, pension funds and retail investors as much as $5 billion a year due to “sub-optimal routing”, according to a report released by research firm Woodbine Associates.

The 75-page report found that the majority of bad routing decisions (when trades are not sent to the exchange offering the best price) occur because of rebates. “Many orders are not routed to the right venues at the right time for the right reasons….economics turn toward the broker and away from the client”.

Simply put: rebates are just another conflict of interest, and just another way that Wall Street firms are able to take a profit at the expense of investors. And as a former Securities and Exchange Commission chief economist put it: “in other contexts, these payments would be recognized as illegal kickbacks”. Rebates might not be illegal, but that doesn’t make them right.


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